19

Small-scale Industrialisation

Small Industry

Rationale for supporting Small-scale Enterprises:

THE arguments advanced in the literature for promotion of small-scale enterprises
involve both certain desirable characteristics of such enterprises and also a common
belief that under normal market conditions many such enterprises would not be able
to survive in the economy. A list of such desirable characteristics of such enterprises
include, inter alia, higher labour intensity and related positive income distribution
effects, their potential for balanced regional development through greater
decentralisation, their contribution to the promotion of entrepreneurship, their
flexibility in operation, and their ability to export. If these positive characteristics are
seen to be important and if there is reason to believe that market failures inhibit the
growth of small-scale enterprises, then it would be appropriate to frame policies that
attack these market imperfections.
It is believed that small-scale enterprises are hampered in their growth because of
imperfections in factor markets, in labour, capital and land. Typically, the factor
market most focussed on is the capital market, distortions in which are seen to
especially discriminate against small-scale enterprises. Similarly, imperfections in the
labour market lead to factor price distortions causing larger than justifiable wage
differences between large and small enterprises. It can be argued, however, that the
higher wages facing large firms can generally be compensated by higher efficiency of
the workforce so that the wage cost difference per efficiency unit of labour is much
less than the observed difference in the prices of capital. Thus, it can be argued that
distortions in the capital market are much more important than those in the labour
market. Large firms are able to compensate the higher wages through higher
efficiency, but small firms are not able to compensate for the high cost of capital
through higher efficiency of the capital used. Similarly in the land market small
enterprises could face greater regulatory hurdles in achieving appropriate access to
land.
The economic argument would then be that in the face of factor market distortions
special support policies for small-scale industries would tackle the problems at their
source. The best solution would be to enact policies that remove the various factor
market distortions that are observed at their source. In practice, it is found that it is
difficult to remove such factor market distortions through direct interventions. The
result is that a whole plethora of other supportive policies for small-scale enterprises
are observed. India has differed from other countries in its degree of concern for
supporting small scale enterprises. In fact, amongst developing countries, India was
the first to display special concern for small-scale enterprises, before it became
fashionable to do so. A basic focus of Indian government thinking has been that
employment generations are of paramount importance in a labour surplus economy.
Small enterprises manufacturing labour intensive products make economical use of
capital and absorb abundant labour supply which characterises an under developed
economy. The belief has been that large enterprises are capital intensive and reward
only a small minority of labour which is skilled and urban. Indian concern and
support for small scale enterprises has focussed excessively on small-scale industries
as distinguished from small-scale enterprises in general. This can perhaps be tracked
back to Mahatma Gandhis special concern for handicrafts and village-based
industries. In the nineteenth century, there was a widespread perception in India that
the import of handloom textile workers and other craftspeople, and this experience
also contributed to the special concern for protecting SSIs.
All industrial policy Statements since Independence have provided some special
attention to the problem of small-scale industries.
The basic structure of institutional promotion of small-scale industries was put in
place in the 1950s. The institutional structure had aimed to provide for a development
programme for small-scale industries through the establishment of organisations for
providing technical assistance and industrial extension.
The basic idea then was promotion of small-scale enterprises through positive
technical and marketing support.
A policy of reserving items for the exclusive manufacture in the small-scale sector
began in 1967 when 47 items were reserved. This number rose gradually to 180 by
1976. With the 1977 Industrial Policy Statement a major expansion took place in the
number of items reserved for small-scale sector. A major shift in small-scale industry
policy took place with the promulgation of the Industrial Policy Statement of 1977. It
was then decided that the sole criterion for reservation of products in the small-scale
sector would be merely its ability to physically manufacture them. It was stated in the
policy that whatever can be produced on a small scale must be so produced. The
regime for small-scale industry developed has remained virtually unchanged after
that.
The key elements of Indias policy for the support of small-scale industries have
been small-scale industry reservations, fiscal concessions by way of lower excise
duties, preferential allocation of and subsidisation of bank credit, extension of bank
services by the government, and preferential procurement by the government. Thus,
small scale industry has been sought to be protected from the competition of large
companies both through reservations as well as fiscal concessions. Extension of
business services by the government was considered necessary in the absence of
equivalent services being available in the private sector.
In his study, Rakesh Mohan has argued that this support structure may have
reflected well the needs of the 1950s, 1960s and 1970s. The argument is that these
policies have now become obsolete and are now likely to be harmful to the
development of small scale industries and of industrial development in general. There
has been vast growth of small units over the years. Thus, the governmental structure
for technical support of small-scale industries has become both obsolete and
inadequate. There is now much greater availability of private sector business and
technological support service which should be fostered. Second with the opening of
the economy the reservation policy has become counterproductive. Third, fiscal
concessions can also be operating so as to discourage growth into large units. Thus, it
is argued that a whole new approach for supporting small-scale industries has to be
adopted in India to serve the changing needs of the new open economy.

Definition of Small-scale Industries:

Most countries define small-scale industries or enterprises in terms of employment
levels. Usually small-scale industries are taken to be those units which employ more
than 5 but less than 50 or 100 workers. India is among the few countries that has used
investment ceilings to define small-scale industries. Further, in India itself, different
definitions are used for different purposes. The Factories Act defines a factory as one
which employs 10 workers or more if the unit uses power, or 20 workers or more if it
does not use power. All such units have to be registered under the Factories Act and
are subject to various labour laws including the provision of medical insurance and
some social security. This is known as the registered sector. Within, this definition
those units which employ more than 50 workers (if using power) or more than 100 (if
not using power) have to compulsorily register themselves with the state governments
in order to operate. The main source of data for manufacturing is the Annual Survey
of Industries (ASI). The coverage of this survey is limited to those factories which are
registered under the Factories Act. The third definition is that used for giving fiscal
concessions. At present units which has less than Rs. 3 million turn over are fully
exempted from the excise taxes and there is a sliding scale of concessions available
for small-scale enterprises which have turnover of up to Rs. 30 million.
In 1950, the investment limits was up to Rs. 0.5 million in fixes assets employing
less than 50/100 persons with or without power. From 1960 onwards, there are no
conditions regarding employment but investment limits has been raised to keep up
with the inflation and hence to preserve the real value of investment limits. In 1966
Investment limit was raised to 0.75 million in plant and machinery then 1 million in
1975, 2 million in 1980, 3.5 million in 1985, up to 6 million in 1991 and up to 30
million in 1997. A curious development took place in 1999 when, for the first time, a
reversal in investment limit was put into effect by lowering the investment limit to 10
million. The current definition is therefore more restrictive in real terms relative to
1991.
The current status of the investment ceilings for small-scale industries is provided
in the following statement.
STATEMENT

Investment Ceiling for Small-scale Industry(December 1999)

Type of small- Investment Limit Remarks

scale Industry

Small-scale Industry Rs. 10 million Historical cost of plant and machinery

Ancillary Rs. 10 million At least 50 per cent of its output should go to other industrial
undertakings
Export Oriented Rs.2.5 million Obligation to export 30 per cent of production
Tiny Enterprise Rs.0.5 million No location limits
Service and Rs. 10 million No location limits
Business Enterprise
Women Enterprise Rs. 10 million 51 per cent equity holding by women

Small Scale Reservation Policy:

The policy of small-scale reservations was initiated in 1967 as a promotional and
protective measure for the small-scale sector vis--vis the large-scale sector. Under
this policy selected products are identified for exclusive production in the small-scale
sector. The overwhelming consideration for reservation is whether it is technically
feasible to produce that item in the small-scale sector, the manufacturing process is of
a simple nature i.e. is essentially labour intensive, and whether the small scale units
can meet the requirements of consumers both in terms of quality and quantity. The
rationale for reservation was based on the advantages of the small-scale sector like
labour intensity and adaptability to a semi-urban and rural environment. Another
objective was to make SSI products competitive with those of the large scale by
offsetting the disadvantage of mass scale production, economies of scale, wider
marketing network, better credit availability and publicity through mass media and
advertisements.
 In April 1967 there were only 47 items in the reserved category which increased to
504 by April 1978. In 1978 it was decided to recast the reserved list by following
codes adopted in the NIC and in this process, the list of reserved items expanded from
504 to 804. The number had increased to 873 in October 1984 and in 1989 after some
dereservation it came down to 836.
Throughout this whole period of reservation there has been little analysis of the
effects of this policy. The government has conducted two small-scale industries
censuses so far; one in 1972 and the other in 1987-88. The share of production in the
reserved categories was 25 per cent in total small-scale industry production in 1972
and 28 per cent in 1997-98. This small increase in the share was surprising given the
large-scale expansion of products under reservation that took place in 1977. In both
cases capacity utilisation in units producing reserved items was 47 to 48 per cent on
average, whereas the average level of capacity utilisation was over 50 per cent in units
producing unreserved items. It was also found in 1987-88 that a large number of
reserved items were not produced at all in any unit.
The second census of small scale industries provides persuasive evidence of the
misplaced importance given the policy of reservation. Out of a total of 200 products
leading in value of output produced by the small scale sector, it was found that
reserved products accounted for only 21 per cent. Only 21,000 small scale units, less
than half out of a total of 5,82,000 units, manufactured the reserved products at all.
No less than 233 reserved items out of a total of 1,076 (when expanded at a lower
level of aggregation in the NIC code) were found not be manufactured at all according
to the census. Although further inquiries have revealed that many of these products
are found to be manufactured by some units, the fact remains that their production is
in negligible quantities.
Conversely, very few of the reserved products attracted significant levels of
participation from small-scale units. As many as 90 products were found to be
manufactured by one company each. The sum total of the value of production of all
small-scale companies in as many as 692 items was a low of Rs. 100 million or less.
Just 68 reserved items accounted for 81 per cent of the total value of the production of
reserved products and 83 per cent of the units.
In recent years, with opening of Indian trade almost 75 per cent of all reserved
items are now already importable with the removal of quantitative restrictions (QRs)
in the last few years. India is also committed to remove the remaining of QRs by April
2001. We, therefore, now have a curious situation that reserved items can be produced
by large foreign enterprises and imported into India whereas Indian large enterprises
are not allowed to produce the same items! Even this change in the external
environment has so far not persuaded the authorities to change this policy of small-
scale industry reservation.
Reviewing the framework of Indian policies protecting and supporting small-scale
industries, Rakesh Mohan remarks That these policies and programmes are thinly
spread thereby leading to relative ineffectiveness. Many of the policies are such that
discourage growth of small scale units into larger ones and thereby are likely to have a
stunting effect on manufacturing employment and output growth. Some of these
policies may have been useful in the earlier stage of Indian industrialisation and in the
context of a highly controlled and closed economy. With all the changes in economic
environment that have taken place in the 1990s the indication is that future policies
for the promotion of small-scale industries must be more growth oriented and more
general rather than being sector oriented. It would be more useful if such policies are
designed to promote entrepreneurial entry, growth of enterprises technology up
gradation and labour productivity in a pervasive manner regardless of specific
sectors.

Spatial Distribution of SSEs:

One of the aims of Indias SSI policy was the dispersed development of units in
rural areas and its less developed backward areas. There has been only limited
success in attaining this objective.
The SIDO figures suggest that 85 districts with more than 2,000units in each
account for 51 per cent of the total. More than 81 per cent of SSEs are concentrated in
204 districts, and more than 50 per cent of the districts do not have any significant
number of enterprises (NCAER, 1993 3.7.6, p.81).
Rakesh Mohan argues, the objective of dispersal might be in conflict with the
dynamic growth of modern and efficient growth. There has been important spatial
concentration of SSEs in clusters in particular product lines. The external economies
which these clusters generate in terms of easy availability of raw materials, skilled
labour, markets, etc. have been known to have been instrumental in the growth of
SSEs in many countries, including Italy and Germany. India is providing no exception
to this basic economic impulse. It is appropriate that these trends might be more
emphatically encouraged in official policies and objectives. A closer look needs to be
taken at the methods for fostering development in backward areas through such
methods as tax concessions and special allotment of scarce materials.

Impact of SSI Reservation on Exports:

According to Rakesh Mohan, the policy of small-scale industry reservations has
had a very deleterious effect on the growth of both manufacturing employment and
exports. An important feature of industrialisation of the fast growing East Asian
countries during the last three decades or so has been high growth in manufactured
exports accompanied by high growth in manufacturing employment. The Indian
experience has been different. Our record of growth in manufacturing employment
has been poor and so has our export growth. The share of exports in Indian GDP has
barely reached 10 per cent now. Although this is a significant improvement over the 3
per cent share of 1970 and 5 per cent in 1980, the Indian economy remains the least
open among major countries in Asia, including China. The volume of Indian exports
in 1970 was the third highest among the 10 Asian countries. Today it is the second
lowest. While Chinese exports grew from US$ 18 billion in 1980 to about US $ 120
billion in 1994 Indian exports during that period grew from US $ 8.6 billion to US $
25 billion. Given that the composition of exports of industrialising countries is largely
labour intensive, one of the reasons behind slow employment growth in
manufacturing in India is clearly related to the slow growth in exports.
It is possible that the damage caused by such policies was not very high in the
1970s, when competition in exports of low technology was not high as it is now.
Furthermore, changing industry structure and demand patterns in the developed world
now place a much higher premium on product quality and service quality with the
inexorably rising incomes there. The average quality demanded for products such as
clothing, footwear, toys and sports equipment and the like is getting higher and
higher. Furthermore, the integration of the information technology in even these
industries also requires greater investment and greater labour sophistication. Such
products are no longer seen as free standing products but are increasingly becoming
parts of long value chains with the share of value added in plain manufacturing
perhaps falling. Higher quality requires high level designing upstream even for simple
 products. Downstream marketing involves linkages with large organisations which
buy such products in bulk. Small enterprises sandwiched between such high level
organisations find it increasingly difficult to operate and be competitive. Thus, apart
from the loss that India has suffered over the last 2-3 decades it is likely that the
future scenario will become even more difficult for Indian small enterprises to
survive, particularly in the reserved sector. Another issue of note is the prospective
dismantling of the Multi-Fibre Agreement. Paradoxically, although it may have
seemed that textile quotas were inhibiting Indian exports, it is likely that we are
actually protected through the MFA mechanism. This is shown in Somnath Chatterjee
and Rakesh Mohan (1993) who documented the fact that Indian clothing exports went
primarily to quota countries and were almost absent in the markets of non-quota
countries. Thus, the removal of small-scale reservation is especially necessary in the
item affected by the removal of MFA.
Looking at the record of Indian exports in comparison with East Asian countries,
it is difficult to avoid the conclusion that Indian exports have been constrained by the
policy of SSI product reservation.
The major conclusions of Rakesh Mohans study are given below:
We may distinguish the small scale modern sector-consisting of units employing 6 or
more workers and the tiny sector including household enterprises. In terms of
employment around 1990, the former accounted for roughly 20 per cent of all
manufacturing employment, but nearly a half of employment in the modern
manufacturing sector. The tiny and household sector is 2.5 to 3 times as large,
depending on whether or not we include secondary workers in the labour force. The
contribution of SSI in terms of value added is, of course, much smaller-only a third as
far as the modern manufacturing sub-sector is concerned and no more than 40 per cent
of all manufacturing value added. The last point emphasises the enormous difference
in labour productivity between the different sub-sectors of manufacturing.
As in other countries, the household sub-sector has declined slowly over the last two
or three decades. A more surprising finding is that in spite of the vigorous policy of
protecting the small scale industry, this decline has not been fully compensated for by
the growth of non-household production in the small-scale sector. The SIDO figures
of high growth rates of SSIs under their purview seem to be grossly exaggerated.
In spite of the vast increase in the number of reserved items, much of the growth in
the SSI sector seems to have been in product lines outside the reserved list. It is
possible that the policy of reservation might be merely protecting inefficient units in
stagnant industries.
A finding of some concern is the unequal distribution of units of small and large sizes
within the SSI sector. There seems to be an increase in the concentration of output in
larger units over the last two decades. A comparison of the data from the two SIDO
censuses of 1972 and 1987-88 show a sharp fall in the mean employment size but an
increase in capital-intensity of the SIDO units-which is consistent with a more skewed
distribution of enterprises, and increased contribution of the more productive units.
The claim that there has been substantial dispersal of units to backward and rural
areas under the SSI policy might be exaggerated. As far as the modern SSIs are
concerned there is considerable evidence of spatial concentration of SSEs in
clusters in specific product groups. We have already emphasises in earlier chapters
that there is a need for policies of de-centralisation to come to terms with the
economic logic of external economies which clusters provide.
 All the evidence suggests that the Indian manufacturing sector is likely to have been
constrained by the various, anti-growth policies promoting the small-scale sector,
particularly that of product reservation. Indian manufacturing employment growth has
been the lowest among large Asian countries over the past three or four decades.
A particular casualty of SSI product reservations has been growth in Indian
manufacturing exports. A large number of categories in which exhibits comparative
advantage have been reserved for SSI. Consequently, Indian industry is unable to
upgrade quality on a continuous basis and is also not able to diversify to higher
technology and higher value added item, thereby stunting export growth.

New Small Enterprise Policy

The document on the new small enterprise policy (NSEP) titles policy measures
for promoting and strengthening small, tiny and village enterprises was tabled in the
Parliament on August 6,1991. The NSEP is presented under the major heads of (a)
small and tiny enterprises, and (b) village industries. Since the emphasis on objectives
in the NSEP of these two groups is not the same, as also because the measures
proposed for them are substantially different, it is best to examine the NSEP
separately under these heads.

Small and Tiny Enterprises:

The primary objective of the NSEP as mentioned under the above head is to
impart more vitality and growth impetus. In as much-as vitality is founded basically
on cost-efficiency, and is prone to promote growth, the NSEP may be said to have for
this sub-sector, the objective of increase in efficiency, and through it to promote
growth of output, employment and exports. In this context, a number of changes are
proposed, but four, according to Sandesara, are path-breaking. They are discussed in
detail below.
First the definition of a tiny unit is changed, and this change is two-fold. It may be
recalled that the industrial policy of May 19990 had announced an increase in the
investment limit of tiny units from Rs. 2 lakh to Rs. 5 lakh. However, it had retained
the location requirement to villages and smaller towns (limit of 50,000 populations).
The NSEP has done away with this requirement. The population of tiny units will,
thus, increase, as all units within the investment limit of Rs. 5 lakh and located in
bigger towns (population of 50,000 plus) will now become a part of the tiny group.
The other definitional change is more basic. Earlier, industry meant, by and
large, manufacturing industry. The NSEP has widened the scope to include industry-
related services and business enterprises also. All such enterprises, irrespective of
their location are now recognised as small-scale industries, but their investment
ceiling corresponds to those of tiny enterprises. What we really have now, is, thus, a
tiny enterprise/business policy instead of a tiny industry (manufacturing) policy as
earlier. Thus, this change also increases the number of enterprises in the small sector,
more than in the tiny group.
This is to be welcomed for three reasons. First, service and business activities are
more labour-intensive than manufacturing activities. Thus, state assistance to these
activities will sub serve the employment objective. Second, of late, a number of large,
high wage/salary paying companies in the manufacturing sector have been getting
considerable auxiliary, serving work done from outside-from smaller, low wage/salary
enterprises to reduce the cost of such services. Among such activities are: cleaning,
security, typing, transportation and distribution, catering, etc. Partly because of this as
also because of other developments, over the years the tertiary sector has grown
greatly in relative terms, following the growth of the secondary sector. To illustrate,
the formers share in gross domestic product increased from 28 per cent in 1950-51 to
39 per cent in 1989-90 and the latters from 15 per cent to 27 per cent, with a
corresponding decline in the share of the primary sector from 56-24 per cent over the
same period. With its share of nearly two-fifths, the tertiary sector has now become
the largest, and cannot be neglected by the state. Third, in the US, in the UK and in a
number of other countries, for the small sector. It has been really a small business
policy and not an industry policy. It is, thus, in the fitness of things that the NSEP
includes non-manufacturing service enterprises.
The third major change relates to equity participation. The NSEP provides for
equity participation by other industrial units in the small industrial units not exceeding
24 per cent of the total shareholding. This provision should prove mutually beneficial
to both large units and the small units, especially ancillary units, and cement further
the economic bonds between the two sectors. Marketing is one of the most difficult
problems of small industry, and ancillarisation takes care of this problem in varying
measures. Large units are also known to take care of the working capital and quality
problems of small units, by giving them advances and by making available their
testing facilities. The provision of equity participation not only relieves the small units
of the burden of full equity funding, but it also builds up the stakes of large units in
the survival and growth of small units.
The fourth special feature of the NSEP is the introduction of a new legal form of
organisation of business, namely, restricted or limited partnership. In this form,
liability of at least one partner is unlimited, whereas other partners have their liability
limited to invested capital. Following the example of US and Japan, the A.R. Bhatt
committee had recommended the introduction of this form of organisation in the 70s,
but no follow-up action seems to have been initiated until the NSEP. This is a
welcome provision. It will attract equity capital especially from friends and relatives
of the entrepreneurs of small nits, who may like to help their kith and kin, but who
fight shy because of unlimited liability in the partnership firm (under which a large
number of small units are organised). On the other hand, small units short of funds but
wishing to avoid sharing of decision-making will welcome argumentation of risk
capital from such silent partners.

Village Industries:
Although the objectives and policy measures for village industries are presented
separately for handlooms, handicrafts and other village industries, there is a lot that is
common for them in the NSEP as regards both objectives and measures. To avoid
repetition, it may therefore be best to examine first the proposals of the NSEP for
these industries together and then draw attention to their special features individually.
A main objective for the group of village industries seems to be, as the word
village suggests, to promote rural industrialisation. The other major objective is to
promote employment, with a view especially to help the weaker sections of society.
Thus, here, employment is more welfare-oriented than efficiency -oriented.
A number of measures are proposed to serve these objectives. Almost all the
measures of routine type, and relate to supply of raw materials, sale of products, up
gradation of production methods and improvement in the quality of products,
expansion of training facilities, strengthening of the existing organisations, etc.
The NSEP has broadened the definition of tiny and women enterprises. It has
also introduced a new form of legal organisation-restricted partnership-to enable small
units to raise equity from private sources. It also permits limited equity participation
by other industrial enterprises. It also envisages greater role of non-government
agencies like co-operatives, industry associations, voluntary agencies and the like in
administering some assistance programme. It also speaks of simplifying rules and
procedures.

Performance of Small-scale industries

The performance of small-scale industries sector in terms of critical parameters

like number of units (both registered and unregistered), production, employment and
exports is given in the table 19.1.
According to economic survey 2006-0, the micro and small enterprises (MSEs)
constitute an important segment of the Indian economy, contributing around 39 per
cent of the countrys manufacturing output and 34 per cent of its exports in 2004-05.
It provides employment to around 29.5 million people in the rural and urban areas of
the country (table 19.1).

TABLE-19.1

Performance of Micro and Small-scale Enterprises

No. of units(lakh) production (Rs. Crore) Employment Exports

Year (in lakh) (Rs.
Regd. Unregd. Total (at current (at constant crore)
prices) prices)

2002-03 15.91 93.58 104.49 3,11,993 2,10,636 260.21 86,013

(4.1) (10.5) (7.7) (4.4) (20.7)

2003-04 16.97 96.98 113.95 3,57,733 2,28,730 271.42 97,644

(4.1) (14.7) (8.6) (4.3) (13.5)

2004-05 17.53 101.06 118.59 4,18,263 2,51,511 282.57 1,24,417

(4.1) (16.9) (10.0) (4.1) (27.4)

2005-06 18.71 104.71 123.42 4,76,201 2,77,668 294.91 N.A

(4.1) (13.9) (10.4) (4.4)

Note: figures in parentheses indicate percentage growth over previous years

Source: Development Commissioner (SSI)

This sector has the second largest share of employment after agriculture and spans
a wide range, including small-scale, khadi, village and coir industries, handlooms,
handicrafts, sericulture, wool, power looms, food processing, and other agro and rural
industry segments. It touches the lives of the weaker and unorganised sections of the
society with more than half of these employed being women, minorities, and the
marginalized. Fifty seven per cent of the MSE units are owner-run enterprises with
one person. They account for 32 per cent of the workforce and 29 per cent of the
value added in non-agricultural private unincorporated enterprises. Infusion of
appropriate technology, design skills, modern marketing capacity building and easier
access to credit can make this segment an expanding base of self-sustaining
employment and wealth generation and also foster a culture of creative and
competitive industry. Agro-food processing, sericulture and other village enterprises
can check rural-urban migration by gainfully employing people in villages. This will
also take pressure off agriculture. The MSE sector can open up a window of
opportunities in regions like the North East where large industries cannot be set up
due to infrastructure and environmental concerns.
Several ministries/departments/institutions deal with activities falling within the
domain of the MSE sector, and have a variety of schemes to support the MSEs.
However, the benefits accrue to only a small fraction of MSEs as only 13 per cent are
registered. In the 11th plan we need to adopt a dual strategy to ensure that the
unregistered micro and small enterprises and units outside the cooperative fold are
encouraged to get them registered and are also able to benefit from government
schemes, pending registration. In fact, the provision of voluntary filing of enterprise
memoranda by micro and small enterprises in the new micro, Small and Medium
Enterprises Development Act, 2006 is a step in that direction and should be
implemented energetically.
The approach paper to the 11th plan states there is need to change the approach
from emphasis on loosely targeted subsidies to creating an enabling environment. A
cluster approach can increase viability by providing these units with infrastructure,
information, credit, and support services of better quality at lower costs, while also
promoting their capacity for effective management of their own collectives. The 11th
five-year plan should restrict subsidies to those needed to create a level playing field
and to reflect the cost or benefits to others in the society. It should incentivize
innovation and creativity. It should remove all entry barriers and migrate business
risks for start-ups, the latter, inter-alia, through a large number of well managed
business incubators in the identified thrust areas of manufacturing. It should provide
infrastructure and liberate MSEs from the inspector raj. Further, in order to improve
the competitiveness of these micro, small and medium enterprises, schemes for
establishment of mini tool rooms, setting up design clinics, providing marketing
support, sensitization to IPR requirements and tools, etc., should be evolved on a PPP
basis. Brand building can be used as an effective strategy to promote their products in
national and international markets.
After due consultation with the stakeholders, 180 items reserved for exclusive
manufacture in micro ad small enterprises have been de-reserved on May 16, 2006
and 87 such items have been deserved on January 22, 2007.
The logic of deserving items for domestic production exclusively in the small-
scale sector, particularly when such products can be freely imported from large-scale
production units abroad and when such a policy prevents the small from growing
and benefiting from the economies of scale, has progressively come under serious
questioning. However, the question that needs to be addressed is whether the
reservation in the small-scale sector is based on any objective policy parameter. The
process of reservation of items for production exclusively by the small-scale sector
started in 1967 and reached its peak in 1984 with 873 items reserved for small-scale.
There has been a gradual relaxation of the reservation policy over time, and the
number of items reserved for the small-scale sector was 239 on January 22, 2007.

20
 Role of Foreign Capital

Introduction
THE growth-augmenting role of external trade and foreign capital flows has
assumed critical importance in India in recent years. The overall shift in the policy
stance in India from export pessimism and foreign exchange conservation to one that
assigns an important role to export of goods and services in the growth process has
primarily been guided by the perception that an open trade regime could offer a
dynamic vehicle for attaining higher economic growth.
Structural reforms and external financial liberalisation measures introduced in the
1990s in India bought in their wake surges in capital flows as well as episodes of
volatility associated with the capital account dictating the balance of payments
outcome. Large capital inflows enabled an easing of resource constraints and an
acceleration of growth in the mid -1990s. In the second half, the foreign exchange
market developments as well as the rapid transmission of international sell-offs
facilitated by cross border integration equity markets via capital flows have provoked
a reassessment of the benefits and cost of employing capital flows as a lever of
growth. Throughout the 1990s, the role assigned to foreign capital in India has been
guided by the considerations of financing a level of current account deficit that is
sustainable and consistent with the absorptive capacity of the economy (Rangarajan,
1993; Tarapore, 1995; Reddy, 2000). In the aftermath of South-East Asian crisis,
however, the need for further strengthening the capacity to withstand vulnerabilities
has necessitated a shift in policy that assigns greater weightage to stability (Reddy,
2000).
The experience of developing countries with harnessing capital flows for growth
over the last two decades has been mixed. The actual impact of capital flows on
economic growth varied widely across countries, depending on country-specific
conditions and the nature of policies for external capital. Accordingly, it becomes
necessary to empirically evaluate each countrys experience in terms of the specific
role assigned to foreign capital in the process of development. This includes an
assessment, however subjective, of the negative externalities associated with capital
flows. Negative externalities could emanate both during periods of surges and sudden
reversals. Besides real appreciation of the exchange rate, surges in capital flows could
facilitate imprudent lending and overheating associated excessive capacity addition,
which may give rise to banking crises. Sudden reversals of capital flows, particularly
in cases of short-term banking flows and portfolio flows, could trigger sudden
collapse of asset prices and exchange rate and thereby adversely affect growth.
This chapter undertakes an empirical assessment of the contribution of foreign
capital to the growth process in India. Macroeconomic analysis weighing the role
foreign capital vis--vis exports (of goods and services) as a growth accelerator in a
developing country context is presented in section I. section II encapsulates the
important features of the role of foreign capital by drawing on the theoretical and
empirical literature on the subject. Different viewpoints on the role of alternative
forms of foreign capital and the changing importance of each form of capital over
time are also discussed. A brief overview of the Indian policy framework for attracting
foreign capital during the period of planned development is set out in section III, with
specific empirical findings presented in the context of the shifts in the policy regime.
Section IV suggests a realistic FDI policy. This is followed by concluding
observations.
 I
FOREIGN CAPITAL VERSUS EXPORT-LED GROWTH

The standard analysis of growth accounting in an open economy encounters an

apparent contradiction between export led growth on the one hand, and capital-flow
included growth on the other, even though in reality both strategies could be
operationalised simultaneously to strengthen the growth process. The apparent
contradiction arises from the macroeconomic identity [Y=C+I+G+(X-M)] which
suggests that while a surplus in the external goods and services account- reflecting the
result of an export-led growth strategy- could increase GDP, that would tantamount to
no role for net external financing as the country must necessarily save more than it
can invest, leading to net capital outflows. The underlying assumption behind this
assessment is that an export-led growth strategy can stimulate growth only by
generating a surplus in the external goods and services account. The actual external
resource transfer process and the stages over which the importance of each form of
transfer changes can explain how a developing country could simultaneously benefit
from both export-led and capital-flow-induced growth strategies.
In a developing country, the consumption level lags behind the consumption
standards of advanced economies and the marginal productivity of investment is
higher. A deficit in the goods and services account and the associated net capital
inflows cannot only enable the economy to bridge its consumption gap but also help
in achieving output convergence with the advanced economies. An export-led growth
strategy could enhance the ability of a developing country to achieve this goal faster
by allowing higher levels of sustainable imports. Sustainable capital inflows to
finance the gap so created would be growth enhancing. In small open economies, a
surplus generated in the trade (for goods and services) account could raise GDP.
Residents would increase their external financial assets, acquired in exchange of real
resources through the trade surplus. Financial assets, in turn, represent command over
future goods and services. An open capital account in such economies helps in
freedom of portfolio adjustment and consumption smoothing to each resident. Small
open economies, however, depend largely on external demand conditions for
sustaining the export-led growth. A slowdown in external demand conditions can give
rise to a large-scale deceleration in domestic GDP growth in such economies. For
example, Singapores external current account exhibited large surplus in recent years
(in excess of 20 per cent of GDP) indicating the role of net exports in growth (IMF,
2001).
There are three possible types of resource transfers in the external account, viz,
real against real, financial against real, and financial against financial. Priority is
greatly assigned to real against real form of resource transfers in the initial years of
development. As a result, exports are regarded essentially as the means to pay for
imports. Since the demand for certain critical real resources may exceed what could
be made available domestically or what could be financed through export earnings, a
bridging role emerges for financial transfers in the form of capital flows. With modest
and gradually increasing recourse to real against financial form of transfer, a role for
foreign capital is envisaged. Only over time, financial against financial form of
transfers-representing an open capital account-can occur. Even though country-
specific approaches to timing and sequencing often widely differ, three phases for
debt related capital flows could be conceived. In the first phase, the country operates
with a resource gap that is financed by inflows of debt capital. During this phase, debt
grows faster than debt servicing. In the second phase, the country generates a positive
 resource balance (in the goods and services account) in the current account, but the
debt servicing exceeds the positive resource balance, giving rise to further addition to
debt stock. In phase three, the positive resource balance position becomes more than
sufficient to finance the debt servicing obligations. As a result, residents accumulate
external assets and the need for debt flows to finance the resource gap disappears
(Simonsen, 1985).
India could conceptually be placed at present in phase-1 of this cycle. An export-
led growth strategy -that ensures export growth to continuously exceed the interest
rate on debt-would enable India to raise its per capita GDP to the threshold level
beyond which generation of a surplus balance in the current account could enable the
residents to accumulate foreign assets. A possible threshold level of per capita GDP
for the developing countries in general could be about US $ 1,000. Effective use of
trade as an engine of growth could help India in achieving a faster transition to the
next phase of the cycle while at the same time internalising the benefits of growth
impulses associated with a more open trade regime.

II
THE DEBATE ON THE ROLE OF FOREIGN CAPITAL

Theoretical and empirical research on the role of foreign capital in the growth
process has generally yielded conflicting results. Conventionally, the two-gap
approach justifies the role of foreign capital for relaxing the two major constraints to
growth-the saving constraint or gap and the foreign-exchange constraint or
gap.(Chenery and Bruno, 1962; Mckinnon, 1964). In the neo-classical framework,
however, capital neither explains differences in the levels and rates of growth across
countries nor can large capital flows make any significant difference to the growth
rate that a country could achieve (Krugman, 1993). In the subsequent resurrection of
the two-gap approach, the emphasis was generally laid on the preconditions that could
make foreign capital more productive in developing countries. The important
preconditions comprised presence of surplus labour and excess productive demand for
foreign exchange. With the growing influence of the new growth theories in the
second half of the 1980s that recognised the effects of positive externalities associated
with capital accumulation on growth, the role of foreign capital in the growth process
assumed renewed importance. In the endogenous growth framework, the sources of
growth attributed to capital flows comprise:
The spill over associated with foreign capital in the form of technology, skills, and
introduction of new products;
The positive externalities in terms of higher efficiency of domestic financial markets;
Improved resource allocation and efficient financial intermediation by domestic
financial institutions (de Mello and Thea, 1995; Bailliu, 2000).
The marginal productivity of capital in India was 58 times that of the United
States as obtained through the standard estimation of Cobb-Douglas production
functions (Lucas, 1990; Taylor, 1994). India, however, could never attract enough
foreign capital to take advantage of the productivity differentials. Unlike the wide
differences in estimated productivity of capital, however, real interest rates-a measure
of real return received by the investors-turned out to be much less divergent across
countries in reality. Capital markets could be imperfect, preventing capital flows from
being driven by productive differentials. Incremental investment would be more
productive in countries with skilled workforce and well developed physical
infrastructure. Thus, the presence of internal growth supportive factors appear
important, not only for attracting higher private foreign capital but also for enhancing
the growth inducing effects of such foreign capital (Lucas, op.cit).
In the recent period, studying the growth augmentation role of various forms of
foreign capital has gained prominence over the general analysis. The findings of these
studies can be conveniently grouped under the classification adopted in the analysis of
the balance of payments in India. This would also reflect the current ordering of
capital flows by type from the point of view of the policy stance (Reddy, 1998).

Foreign Direct Investment:

Capital flows in the form of FDI have been widely believed to be an important
source of growth in recent years. Since the 1970s, imperfections in goods and factor
markets, presence of scale economies and government restrictions on output, trade
and entry have come to be recognised as creating market structures where foreign
capital in the form of FDI contributes to growth (KindleBerger, 1969; Hymer, 1976).
It is eminently plausible that FDI flows might not have existed but for the presence of
these imperfections. The theories of international resource allocation based upon the
spatial distribution of factor endowments suggest the importance of location
advantages as a key driver of FDI flows while the theories of organisation point to
the role of ownership advantage and the advantage of internalising intangible
assets (like technology, brand name and marketing skills). Competitive policies of
nations to attract FDI often work towards reducing the cost of production in a host
country. Favourable tax treatment, protected domestic market and low labour costs
represent the primary pull factors for FDI. Sound control norms also help in creating
the congenial environment for augmented inflows under FDI.
Growth impulses originating from FDI are primarily ascribed to superior
technology and greater competition that generally accompany FDI. Local firms of
many developing host countries also do not invest enough on R&D to offer and
sustain competition with Transnational Corporations (TNCs). Investment on R&D by
TNCs in foreign affiliates is, however, found to be low, accounting for as little as 1
per cent of the total R&D investment even though TNCs are generally viewed as
R&D intensive (UNCTAD, 1999). Despite the usual concerns that inappropriate
technology is generally transferred to the foreign affiliates, empirical assessments
suggest that technology -both public and private-that accompany FDI are
complementary and inter-firm collaboration helps in augmentation growth. In such
cases, also FDI may augment growth in a country if its initial technology gap is higher
and openness to FDI is significant.
Whether FDI promotes competition or facilitates development of oligopolistic
structures depends upon whether FDI crowds-out or crowds-in domestic investment.
FDI can potentially displace domestic producers by pre-empting their investment
opportunities. It is possible; however, that the adverse growth effect emanating from
crowding-out could be more than offset by the increase in productivity resulting from
advanced technology that often accompanies FDI.
Since trade is an important vehicle for growth, FDI could also contribute to
growth by promoting exports. For sustaining an export-led growth strategy, it
becomes important to attain dynamic shifts in comparative advantage and FDI can
play a major role in imparting the desired dynamism on account of its global
marketing network.

Portfolio Capital:
 Portfolio capital has emerged as the key channel for integrating capital markets
worldwide. For developing countries, the growth process in the initial phase is often
characterised by self-financed capital investment, which is replaced by gradually by
bank-intermediated debt finance and supplemented over time by both debt and equity
from the capital market. Portfolio capital flows can ease the constraint on growth
imposed by illiquid and small sized capital markets in the early and intermediate
stages of the growth process. Countries that reduced barriers to portfolio flows exhibit
significant improvements in the functioning of their stock markets. Greater liquidity
in the capital market makes it possible to take up investment projects in developing
countries that require lumpy and long-term capital. Equity, unlike debt, allows a
permanent access to capital.
Surges in portfolio flows can, however, adversely affect growth. Greater liquidity
and opportunities for risk diversification may reduce household saving and excess
volatility in the stock market may hinder investment. The problem of market
imperfection and asymmetric information amplifies the volatility resulting from
sudden shifts in the pattern of portfolio flows. Portfolio flows can hinder export
promotion by exerting upward pressures on the exchange rate and also sustain an
import-cum investment boom to overheat the economy. Unlike FDI, for the portfolio
flows there is no one-to-one relationship with real investment. When portfolio
activities are entirely concentrated in the secondary market, there is no direct link with
real investment in the economy. At the macro level, portfolio flows finance the current
account gap when alternative forms of foreign capital prove inadequate. Otherwise, it
is only by enhancing the efficiency and liquidity of capital markets that portfolio
flows can propel growth.

External Aid:
The role of external aid in enhancing growth has waned in recent years. In several
developing countries, including India, public and publicly guaranteed capital flows
have been supplanted by a growing recourse to private capital flows. In some
countries, the problem of negative resource transfer associated with aid has emerged
as an additional balance of payments/growth constraint. Except for the poorest
countries and those with very limited access to commercial capital, a general sense of
aid fatigue has set in. donors have also gradually de-emphasised the role of aid in
international economic relations resulting in a significant decline in aid flows as
percentage of GDP of the donors since the 1960s.
External aid was initially equated with the need for resource transfer to ease the
financing constraint to growth. The major contradiction that surfaced soon was that
while the poorest countries had the greatest need for external aid, their capacity to
absorb foreign aid was highly unsatisfactory. In the 1980s, structural reforms were
seen as the key to promote growth and the earlier project-linked aid strategy was
supplemented by non-project linked structural adjustment lending as an additional
instrument to augment growth. Lack of sound policy environment in the aid receiving
countries has operated as a major factor in eroding aid effectiveness (World Bank,
1998). Despite the general dissatisfaction with aid effectiveness, factors such as lower
cost and higher maturity of aid in relation to commercial loans has encouraged many
developing countries to maintain their access to aid flows.
An orderly transition from aid dependence to market access for foreign capital is
being pursued by several developing countries. A number of countries have
successfully accessed international markets and raised adequate levels of private
capital to meet the financing gap. It is also being increasingly highlighted that more
aid policy should give way to more trade, requiring a change in the policy stance of
the donors to liberalise their extant restrictions on exports from aid-receivers so as to
allow them to reap the benefits of true competitive advantage and in that process to
reduce their dependence on aid.

Commercial Debt Capital:

Commercial debt capital includes a whole range of sources of foreign capital
where the overriding consideration is commercial, i.e. risk adjusted rate of return.
External commercial loans could include bank loans, buyers credit, and suppliers
credit, securitised instruments such as Floating Rate Notes and Fixed Rate Bonds, and
commercial borrowings from the private sector window of multilateral financial
institutions.
It is generally believed that the potential of banking capital in augmenting growth
would be largely realised in a strong and resilient domestic financial system with
effective supervision and regulation. Despite the diversification in the 1990s in favour
of commercial borrowings from the market, loans from banks continue to dominate
the commercial debt segment for the developing countries.

III
CAPITAL FLOWS AND GROWTH IN INDIA: THE RECENT
EXPERIENCE

Capital flows into India have been predominantly influenced by the policy
environment. Recognising the availability constraint and reflecting the emphasis on
self-reliance, planned levels of dependence on foreign capital in successive plans were
deliberately held at modest levels. Economy in the recourse to foreign capital was
achieved through import-substitution industrialisation in the initial years of planned
development. The possibility of exports replacing foreign capital was generally not
explored until the 1980s. It is only in the 1990s that elements of an export-led growth
strategy became clearly evident alongside compositional shifts in the capital flows in
favour of commercial debt capital in the 1980s and in favour of non-debt flows in
th1990s. The approach to liberalisation or restrictions on specific capital account
transactions, however, has all along been against any big-bang (Box 20.1)
A large part of the net capital flows to India in the capital account is being offset
by the debt servicing burden. As a consequence, net resource transfers have fluctuated
quite significantly in the 1990s, turning negative in 1995-96.
Till the early 1980s, the capital account of the balance of payments had essentially
a financing function (Rangarajan, 1996). Nearly 80 per cent of the financing
requirement was met through external assistance. Aid financed imports were largely
ineffectual in increasing the rate of growth and were responsible for bloating the
inefficient public sector (Kamath, 1992). Due to the tied nature of bilateral aid, India
had to pay 20 to 30 per cent higher prices in relation to what it could have got through
international bidding (Ridell, 1987). The real resource transfer associated with aid to
India, therefore, was much lower. There were occasions when India accepted
bilateral aid almost reluctantly and without enthusiasm because of the combination of
low priority of the project and the inflate price of the goods. The Report of the High
Level committee on Balanced Payments (1993) identified a number of factors
constraining effective aid utilisation in India and underscored the need to initiate
urgent action on both reducing the overhang of unutilised aid and according priority
to externally aided projects in terms of plan allocations and budgetary provisions. Net
resource transfer under aid to India, however, turned negative in the second half of the
1990s.

Box 20.1
Role of Capital Controls in Stabilising the Growth Process
The Indian Approach
India considers liberalisation of capita account as a process and not as a single
event. While relaxing capital controls, India makes a clear distinction between
inflows and outflows with asymmetrical treatment between inflows (less
restricted), outflows associated with inflows (free) and other outflows (more
restricted). Differential restrictions are also applied to residents vis--vis non-
residents and to individuals vis--vis corporate and financial institutions. A
combination of direct and market-based instruments control is used, meeting the
requirements of a prudent approach to management of the capital account. The
control regime also aims at ensuring a well-diversified capital account including
portfolio investments and at changing the composition of capital flows in favour
of non-debt liabilities and a higher share of long-term debt in total debt liabilities.
Thus, quantitative annual ceilings on external commercial borrowings (ECB)
along with maturity and end use restrictions broadly shape the ECB policy.
Foreign direct investment (FDI) is encouraged through a progressively expanding
automatic route and a shrinking case-by-case route. Portfolio investments are
restricted to select players, particularly approved institutional investors and the
NRIs. Short-term capital gains are taxed at a higher rate than longer-term capital
gains. Indian companies are also permitted to access international markets through
GDRs/ADRs, subject to specific guidelines. Capital outflows (FDI) in the form of
Indian joint ventures abroad are also permitted through both automatic and case-
by-case routes. The Committee on Capital Account Convertibility (Chairman: Shri
S.S Tarapore) which submitted its Report in1997 highlighted the benefits of a
more open capital account but at the same time cautioned that capital account
convertibility (CAC) could cause tremendous pressures on the financial system.
To ensure a more stable transition to CAC, the Report recommended certain
signposts and preconditions of which the three crucial ones relate to fiscal
consolidation, mandated inflation target and strengthened financial system.
International developments, particularly the initiatives to strengthen the
international architecture for dealing with the problems arising in the capital
account of a countrys balance of payments, would also influence the timing and
sequence of CAC in India.

In the 1980s, India increased its reliance on commercial loans as external

assistance increasingly fell short of the growing financing needs. The significant
pressures on the balance of payments as the international oil prices more than doubled
in 1979-80 and the world trade volume growth decelerated sharply during 1980-82,
triggered an expansion in Indias portfolio of capital inflows to include IMF facilities,
greater reliance on the two deposit schemes for non-resident Indians-the Non-
Resident External Rupee Accounts (NRERA) (that started in 1970) and Foreign
Currency Non-Resident Account (FCNRA) (that started in 1975)- and commercial
borrowings on a moderate scale. A few select banks, all-India financial institutions,
leading public sector undertakings and certain private corporate were allowed to raise
commercial capital from the international market in the form of loans, bonds and Euro
notes.
The policy approach to ECB has undergone fundamental shifts since then with the
institution of reforms and external sector consolidation in the 1990s. Ceilings are
operated on commitment of ECB with sub-ceilings for short-term debt. The ceilings
on annual approvals have been raised gradually. The focus of ECB policy continues to
place emphasis on low borrowing cost, lengthened maturity profile (liberal norms for
above 8 years of maturity), and end-use restrictions.
Given the projected need for financing infrastructure projects, 15 per cent of the
total manufacture financing may have to come from foreign sources. Since the ratio of
infrastructure investment to GDP is projected to increase from 5.5 per cent in 1995-96
to about 8 per cent by 2006, with a foreign financing of about 15 percent, foreign
capital of about 1.2 per cent of GDP has to be earmarked only for the infrastructure
sector to achieve a GDP growth rate of about 8 per cent.
NRI deposits represent an important avenue to access foreign capital. The policy
framework for NRI deposits during 1990s has offered increased options to the NRIs
through different deposit schemes and by modulation of rate of return, maturities and
the application of Cash Reserve Ratio (CRR). In the 1990s, FCNR (B) have been
linked to LIBOR (London Inter-Bank Offer Rate) and short-term deposits are
discouraged. For NRERA, the interest rates are determined by banks themselves. The
Non-Resident (Non-Repatriable) Rupee Deposit [NR (NR)RD] introduced in June
1992 is non-repatriable, although interest earned is fully repatriable under the
obligation of current account convertibility subscribed to in 1994. In the 1990s, NRI
deposits remained an important source of foreign capital with the outstanding balance
sunder the various schemes taken together rising from about US $ 10 billion at the
close of 1980s to US $23 billion at the close of 2001. Capital flows from NRIs have
occasionally taken the form of large investments in specific bonds, i.e., the India
Development Bond (IDB) in1991, the Resurgent India Bond (RIB) in1998 and India
Millennium Deposits (IMD) in 2000.
The liberalisation process started with automatic approval up to 51 per cent for
investment in select areas. Subsequently, the areas covered under the automatic routes
and the limits of investment were raised gradually culminating in permission for 100
per cent participation in certain areas (particularly oil refining, telecommunications,
and manufacturing activities in Special Economic Zones).
Foreign investment responded favourably to the liberalised policy environment
and the generalised improvement in macroeconomic conditions. By 1993-94, FDI and
portfolio flows taken together emerged as the most important source of external
finance and non-debt flows in the form of NRI deposits, external commercial
borrowings and external assistance. Since then, foreign investment has remained as
the most important form of external financing in India.
It is difficult to assess the direct contribution of these flows, particularly FDI, to
the growth process. Anecdotal evidence suggests that foreign-controlled firms often
use third-party exports to meet their export obligations (Athreye and Kapur, 2001).
Another factor that contributes to widening the technology gap in FDI in India is the
inappropriate Intellectual Property (IP) regime of India. Survey results for 100 US
multinationals indicate that about 44 per cent of highlighted the weak IP protection in
India as a constraining factor for transfer to new technology to Indian subsidiaries for
investment in sector like chemicals and pharmaceuticals, almost 80 per cent of the
firms viewed Indian IP regime as the key constraining factor for technology transfer
 (Lee and Mansfield, 1996). It appears that the lure of the large size of the domestic
market continues to be one of the primary factors causing FDI flows to India.
Spill-over of positive externalities associated with FDI in the form of transfer of
technology is also highlighted as another factor that could contribute to growth. The
relationship between technology imports (comprising import of capital goods and
payments for royalty and technical know-how fees) and domestic technology efforts
in terms of R&D expenditure does not exhibit any complementarities. Foreign
exchange spent on technology import as percentage of domestic expenses on R&D
rather increased significantly in the 1990s I relation to 1980s, suggesting the use of
transfer pricing mechanism to create a gap between the visible and invisible patterns
of resource transfer. The share of imported raw materials used by FDI/FCRC firms
has, more or less, hovered around only 20 per cent. FDI firms, however, outperformed
the overall growth in industrial production in the 1990s.

FDI Policy: A Historical Perspective

Over the last five decades, there have been significant changes in approaches and
policies relating to FDI in India in tune with the developments in the industrial
policies and also foreign exchange situation, from time to time. There is a view in the
literature that the attitude and approach to FDI reflected under current of balance of
payments crisis in the respective periods. Depending upon the thrust and direction of
the policies at different time period, one can identify four distinct phases in the
evolution of the policies:
i. First phase from 1950 to 1967- characterised by receptive attitude or cautious
welcome;
ii. Second phase from 1967 to 1980- marked by restrictive and selective policies;
iii. Third phase from 1980 to 1990- gradual liberalisation; and
iv. Fourth phase from 1991 till date- paradigm shift to open door policy (Jain, 1994,
Subrahmanian, et al., 1996 and Kumar, 1998). Major features of FDI policies during
the above four phases are reviewed below. Exhibit 1 provides the major features of
FDI policies during the four phases.

First Phase 1950-1967:

After independence, especially with the second Five-Year Plan, Indias
development strategy focused on import substituting industrialisation. At that point of
time, the availability of capital, technology, skills, entrepreneurship, etc., was very
limited. Hence, the attitude towards FDI was increasingly receptive (Kumar, 1998).
During this period, FDI was sought on mutually advantageous terms, though the
majority local ownership was preferred. As foreign investment was considered
necessary, foreign investors were assured of non-discriminatory treatment on par with
domestic enterprises. There were no restrictions on the remittances of profits and
dividends. Foreign investors were assured of fair compensation in the event of
acquisition. However, it was provided that, as a rule, the major interest in ownership
and effective control would always be in Indian hands. With the foreign exchange
crisis in 1957-58, FDI policies were further liberalised and offered a host of incentives
and concessions. During this phase, market seeking FDIs have been specially
encouraged by the locational advantage in production as there was protection to local
manufacture in the domestic market. Thus, during this phase, the country had given
cautious welcome to the foreign capital.
 Second Phase 1967-1980:
By the middle of sixties, there was considerable investment in various industries.
Besides, Indias scientific and technological knowledge and infrastructure were
developing and manpower was getting more skilled and constraints on local supply of
capital and entrepreneurship have begun to ease somewhat. On the other hand,
outflow on account of servicing of FDI and technology imports from the earlier
period has begun to rise in the form of dividends, profits, royalties, and technical fees,
etc. These factors forced the government to adopt a more restrictive attitude towards
FDI (Kumar, 1998). Major features of the policies followed during the phase are:
i. Restrictions were imposed on proposals of FDIs without technology transfer and
those seeking more than 40 per cent foreign ownership;
ii. The government listed industries in which FDI was not considered in view of local
capabilities;
iii. Foreign collaborations required exclusive use of Indian consultancy services wherever
available;
iv. The renewals of foreign collaboration agreements were restricted.
v. From 1973 onwards the further activities of foreign companies along with those of
local large industrial houses were restricted to select group of core or high priority
industries. The enactment of Foreign Exchange Regulation Act (FERA), 1973 became
the key to guiding and controlling FDI inflows. The phase of tight regulation and
selective policy was implemented by an administrative system based on discretionary
power.

Third Phase 1980-89:

There was a gradual liberalisation of FDI policies in the eighties due to the
deterioration of foreign exchange position in the wake of second oil crisis and Indias
failure to boost her manufactured exports. Hence, eighties witnessed a gradual but
discernible sign of easing of restrictions on foreign investment inflows with the
liberalisation of industrial and trade policies. Policies were framed to attract more
FDIs and foreign licensing collaborations. During this phase policies were specially
designed to encourage higher foreign equity holding in export-oriented units and
investments from Oil Exporting Developing Countries. Approval systems were
streamlined. A degree of flexibility was introduced in the policy concerning foreign
ownership, and exceptions from the general ceiling of 40 per cent on foreign equity
were allowed on the merit of individual investment proposals. The rules and
procedures concerning payments of royalties and lump sum technical fees were
relaxed and withholding taxes were reduced. The approvals for opening liaison offices
by foreign companies in India were liberalised. New procedures were introduced
enabling direct application by a foreign investor even before choosing an Indian
partner. A fast channel was set up in 1998 for expediting clearances of FDI proposals
from major investing countries, viz. Japan, Germany, the US and the UK. Thus, the
third phase witnessed a concrete move towards liberalisation of FDI policies.

Fourth Phase- 1991 Onward:

There has been a paradigm shift in the policies on FDI from the early nineties with
the adoption of the Industrial Policy Statement of July 1991. One of the objectives of
Industrial Policy Statement was that foreign investment and technology collaboration
will be welcomed to obtain higher technology, to increase exports and to expand the
production base. The Industrial Policy Statement of 1991 has followed an open-
door policy on foreign investment and technology transfer. The policy since then has
been aimed at encouraging foreign investment particularly in the core and
infrastructure structures. During the fourth phase, favourable policy environment
consisting of the liberalisation policies on foreign investment, foreign technology
collaboration, foreign trade and foreign exchange, have been exerting influence on
foreign firms decisions on investment and business operations in the country.
During this period, the FERS, 1973 has been amended and restrictions placed on
foreign companies by the FERA have been lifted. In 1999, FERA has been replaced
with Foreign Exchange Management Act. Government has permitted, except for a
small negative list, access to the automatic route for FDI. Hence, foreign investors
only need to inform the RBI within 30 days of bringing in their investment.
Companies with more than 40 per cent of foreign equity are now treated on par with
fully Indian owned companies. New sectors such as mining, banking,
telecommunications, highways, construction, airports, hotel and tourism, courier
service and management have been thrown open for FDI. Even the defence industry is
opened upto 100 per cent for Indian private sector participation with 26 per cent FDI,
subject to licensing. (FDI is not permitted in the following industrial sectors: 1) arms
and ammunition, 2) atomic energy, 3) railway transport, 4) coal and lignite, and 5)
mining of iron, manganese, chrome, gypsum, sulphur, gold, diamonds, copper and
zinc). The liberal policies have been accompanied by active courting of foreign
investors at the highest level. The international trade policy regime has been
considerably liberalised too with removal of quantitative restrictions lowering of peak
traffics to 30 per cent and sharp pruning of negative list for imports. The rupee was
made convertible on current account and gradually to capital account.
EXHIBIT- 20.1
Major Features of FDI Policies during the Four Phases

Phase 1 Phase 2 Phase 3 Phase 4

1950-67 1967-80 1980-90 1991 onwards

Receptive Attitude or Restrictive Gradual Open Door

Cautious Welcome Attitude Liberalisation Policy

Non- Restriction on FDI Higher foreign Liberal policies

discriminatory without technology equity in export- relating to technology
treatment to oriented units collaboration, foreign
FDI. allowed. trade and foreign
exchange.

No restrictions Above 40% stake Procedure for Encouraging FDI in

on remittance of not allowed. remittance of core and infrastructure
profits and Allowed only in royalty and industries
dividends. priority area. technical fees FERA replaced with
liberalised FEMA

Ownership and FDI controlled by Fast channel for Procedures transparent

control with FERA. FDI clearance Liberal approach for
Indians Discretionary power NRI investments
in sanctioning the FDI need not be
projects. accompanied by
technology
FDI through merges
and acquisitions
FDI in services and
financial sector-banks,
NBFCs, insurance.

Now FDI is permitted under the following four forms of investments: 1) through
financial collaboration, 2) through joint ventures and technical collaborations, 3)
through capital markets via Global Depository Receipts (GDRs) (Euro issues), and 4)
through private placements or preferential allotments.
Transparency and openness have been the most significant features of FDI
policies in the fourth phase. The degree of openness is reflected in 1) the sectors open
to FDI, 2) higher level of foreign equity participation, and 3) transparency in approval
procedures. One striking aspect of the present liberalisation policy is that unlike the
previous phases, it is not necessary that FDI is accompanied by foreign technology
agreements. There is a liberal approach towards investment by non-resident Indian
(NRIs): NRIs and overseas corporate bodies can invest up to 100 per cent in high
priority industries. Another distinctive feature of the policy is the simplification
procedures.
Thus, the ongoing measures taken since 1991 are focused towards a virtual
elimination of the both direct and indirect barriers to foreign direct investment
[indirect barriers in the form of investor protection, differences in accounting
standards, legal and regulatory structure]. In short, the evolution of FDI policies in
India are characterised by receptive attitude till the mid-sixties to a policy of
restrictions and controls till 1980 and then to gradual liberalisation till 1990 and
finally to a policy of full-fledged liberalisation since 1991.

Trends in FDIIn The 1990s

TABLE- 20.1

FDI- Amount Approved, Actual Inflows and Per cent of Capital Formation
(Rs. Crore)

Year Amount Approval Actual Inflow Inflow % of Approval

Inflow % of GCF
1191 534 351 65.8 0.2
1992 3888 675 17.4 0.4
1993 8859 1787 20.2 1.0
1994 14187 3289 23.2 1.4
1995 32072 6820 21.3 2.2
1996 36147 10389 28.7 3.4
1997 54891 16425 29.9 4.7
1998 30814 13340 43.3 3.6
1999 28367 16868 59.5 3.8
2000 37039 19342 52.2 -
2000* 32631 13810 42.3 -
2001* 23266 16127 69.3 -

Note*: January-October, GCF: Gross Capital Formation

Source: Economic Survey 2001-02, Government of India

From a closer look at the data, one can identify two distinct phases in the growth
of FDI during the nineties. The four-year period from 1994 to 1997 is characterised by
high growth of approvals and lower inflows and realisation rate. During this period,
there was a significant rise in the number of projects and amount approved for FDI-
the average annual growth of FDI amount approved was 63 per cent. However,
inflows as a per cent of amount approved were lower: 26 per cent during 1994-97.
Phase I: 1994 to 1997high growth of approval and low growth of inflow and
realisation rate.
Phase II: 1998 to 2001low growth of approvals and high growth of inflow and
realisation rate.

On the other hand, during the next four-year period from 1998 to 2001 (till
October) there was a slow-down in both number and amount of approvals but growth
of inflows and realisation rate was higher. During this low growth phase, the yearly
average number of approvals declined to 1,998 from 2,205 during the high growth
phase. Further, the average annual growth of amount approved during this period was
lower at 12 per cent as against 63 per cent during the previous phase. Though there
was a lower growth of approvals during this period, the actual inflow has been higher
in terms of absolute amount and realisation rate. Average amount of inflow during this
period was Rs. 16,419 crore as against Rs. 9,231 crore during 1994 to 1997. Actual
inflows as a per cent of amount approved rose from 26 per cent to 56 per cent.
Since inflows in particular year need not be entirely related to the approvals given
in that year, it is possible to infer that higher inflows during the second phase may be
on account of lag involved in the realisation of projects for which approvals were
given in the earlier phase. If that is the case, it can also be inferred that lower
approvals during the second phase may lead to lower inflows in the coming years.
The reasons for the reduction in the number of approvals can be traced to : 1) the
effect of restrictions on India following nuclear tests, 2) political uncertainty, and
3)very slow progress in second generation reforms, particularly relating to real sector
and privatisation of public enterprise.

Changes in Sectoral Composition

In tune with the governments priorities with respect to FDI, sectoral composition
of FDI has undergone significant changes during the last two decades. Till 1990, the
government policy was to channel FDI inflow in technology-intensive branches of
manufacturing. Thus, more than four-fifth of FDI stock in 1990 was in the
manufacturing industries. The share of petroleum and power and service sectors was
only marginal. However, with the changes in the FDI policies in the nineties, the
share of manufacturing has been more than halved to 40.1 per cent. Within the
manufacturing industries, FDI is shifting away from heavy capital goods industries to
light industries. With the opening, up of the infrastructure industries, on the other
hand, the share of petroleum and power sector rose substantially to 30.6 per cent in
1999 from just 0.1 per cent of FDI stock in 1990. Similarly, the share of service sector
rose to 27.8 per cent from just 5.2 per cent, respectively, during the above period.
Three high priority industries, namely, power, telecommunication and oil refinery
accounted for nearly half of the total amount of FDI approvals during 1991 to 1999.
Among the different industries, power and telecommunication accounted for the
highest share (17.5 per cent each) of FDI approvals during the nineties. They are
closely followed by oil refinery, which accounted for 13.1 per cent of FDI approvals.
Transportation industry and financial sector were the other two prominent sectors
accounting for larger share of FDI approvals. Thus, what is noticeable in the nineties
in the rise of FDI inflows in the priority infrastructure sectors like power,
telecommunication, oil refinery, transportation, finance and banking. Perhaps, this is
on account of the opening up of these industries for FDI in recent times.

Changes in the Sources of FDI

 Over the years, there has been diversification of sources of FDI. Until 1990,
European countries have been the major sources of FDI inflow sin India. They
accounted for nearly two-third of total stock of FDI in 1990. However, their share
drastically declined to around one-fifth during the nineties. Among the European
countries, the decline was significantly high in the case of UK from 48.8 per cent in
1990 to just 7.6 per cent during the nineties. The share of European countries,
America and Japan taken together accounted for nearly 90 per cent of total stock of
FDI in 1990, however, it has declined to 46.6 per cent during the nineties. The
decline in the share of the above group is essentially due to the rise in the inflows
from other countries. What is more striking is the fact that after USA, Mauritius is the
second largest source of FDI in India. Because of lower taxes in Mauritius, they are
able to attract foreign capital from different parts of the world, which is in turn
invested in countries like India.
Country-wise, the number of approvals of FDI during the nineties shows that USA
accounts for nearly one-fifth of the total approvals. Four countries, namely, USA,
Germany, United Kingdom and Japan, together share around half of the approvals.
Around 95 per cent of foreign collaboration approvals from Mauritius and NRIs are
financial in nature. However, in case of Japan and Italy, technical collaborations are
more than financial collaborations.

Pattern of FDI by Type of Approvals

There are two major routes, namely, Governmentthrough Foreign Investment

Promotion Board (FIPB) and Secretariat for Industrial Assistance (SIA)and the
Reserve Bank, through which FDI approvals are given. An analysis of institution-wise
approval of the amount of inflows reveals that the share of government through
FIPB/SIA has been on the decline and it formed around three-fifth of the approvals in
2001-02. The share of RBIs automatic approval, on the other hand, has increased to
19.4 per cent in 2000-01 from 13.3 per cent in 1992-93. NRI direct investments
constituted around one-third of total FDI inflows in 1995-96. However, of late, their
share has declined and it formed only to 2.9 per cent in 2000-01 as NRI investments
are increasingly taking place in the form of acquisitions of shares of domestic
companies. The share of acquisition of shares by Non-residents rose significantly
from 0.5 per cent in 1995-96 to 15.5 per cent in 2000-01 (Table 20.2).
TABLE 20.2
Share of Different Approval Sources in Actual Flow of FDI

Sources of Approval 1992-93 1995-96 1998-99 2000-01

1. Government (FIPB/SIA) 70.5 58.3 74.0 62.2

2. Reserve Bank (automatic route) 13.3 7.9 7.3 19.4

3. NRIs (40% and 100% scheme) 16.2 33.3 2.5 2.9

4. Acquisition of shares by Non-Residents* 0.0 0.5 16.2 15.5

Total 100.0 100.0 100.0 100.0

Note: * : acquisition of shares of Indian companies by non-residents under Section 5 of FEMS, 1999
Source: Economic Survey 2001-02, Ministry of Finance, Government of India, New Delhi.

Comparative Performance of India and China

 While discussing about FDI in India, often a comparison is made with China, as it
is the major recipient of FDI among the developing countries. According to the World
Investment Report 2001, Indias inward FDI in 2000 stood at US$ 2.3 billion as
against US$ 40.8 billion in China, nearly 18-fold higher than India. Further, the
accumulated stock of FDI in India was US$ 19.0 billion in 2000 as against US$ 346.7
billion in China, nearly 18-fold higher than India. India compares very poorly with
China in terms of inflow of FDI during the last two decades. During the nineties from
1991 to 2000, China accounted for 27.0 per cent of total flow of FDI to developing
countries as against Indias share at 1.0 per cent.
As a result of higher FDI inflows, in China the number of foreign-invested firms
constituted 16 per cent of all companies in 1998, which contributed 24.7 per cent of
total industrial output, 17.6 per cent of total assets and 18.8 per cent of total revenue.
Further, FDI inflows in India as per cent of her gross fixed capital formation and GDP
were very much lower than that of China. In 1990, FDI inflows in India as per cent of
gross fixed capital formation were just 2.4 per cent as against 11.3 per cent in case of
China (Table 20.3). Similarly, FDI inflows in India as per cent of GDP were as low as
3.6 per cent as against 30.9 per cent in case of China (Table 20.4). These facts indicate
that India is relatively slow in restructuring growth and orienting policies to
encourage FDI. The comparison shows that there is considerable scope for attracting
more FDI in India as the country has the potential to absorb it.
TABLE- 20.3

Inward FDI Flows as per cent of Gross Fixed Capital Formation in India and China

Country 1986-1995 1997 1998 1999

India 0.6 3.80 2.9 2.4
China 6.4 14.6 12.9 11.3
Developing countries minus China 4.7 10.9 11.7 13.8

World 4.0 7.5 10.9 16.3

Source: UNCTAD, 2001

TABLE 20.4

Inward FDI Flows as Per Cent of Gross Domestic Product in India and China

Country 1985 1990 1995 1999

India 0.5 0.6 1.7 3.6
China 3.4 7.0 19.6 30.9
Developing countries minus China 14.1 13.4 15.6 28.0

World 7.8 9.2 10.3 17.3

Source: UNCTAD, 2001

Here it is worthwhile to examine why China is able to get more FDI than India
despite het many relative advantages like prevalent English fluency, top-notch
engineers, a well-developed IT industry and low wages. One significant factor cited
for the difference is the contrasting discretion in adopting policies of openness by the
respective governments. Chinese governments pragmatic reform and policy of
 openness is exemplified through their Prime Ministers famous remark, ...it doesnt
matter if a cat is black or white, so long as it catches mice. However, Indias
openness policy is applied to relatively restricted sectors, mainly social overhead
projects such as roads, ports, telecommunication, electricity, etc., where capital
requirement is very large with low profitability.
Another factor is the differences in the structure of local governments and their
authority. In China, local governments play an important role in attracting FDI
because they have a great deal of autonomy in issuing permits as well as offering
various administrative services. Since China is still a highly-planned economy, the
Central governments openness policy tends to be executed easily and efficiently
throughout the economy. In contrast, in India under democratic setup, the sovereignty
of the local governments is well guaranteed, and hence, some of the local
governments are still passive with regard to attracting FDI.
Another inhibiting factor in India is the uncertainty of policy decisions which
obscures predictable future profits and establishment of well-guided management
plans. Factors like lack of well-established investment procedures, unpredictable costs
for factory construction and operation and corrupt bureaucracy aggravates the level of
uncertainty in the eyes of potential foreign investors. The India-China comparison
shows that a governments firm determination to pursue a policy of openness and
capability to ensure efficient coordinated implementation systems can outweigh the
inherent advantages of another government (Kim, 2002).
Another major reason for chinas success is that they are able to attract more
investment from their own people who are doing business in America, Hong Kong,
Macao and in other countries. Further, the level of infrastructure in China is better
than India. On the policy front, in case of India, the initial reform measures were
mostly in the area of financial sector. Only recently reform measures were
contemplated for the real sector. In fact, for attracting FDI, real sector reforms are
essential as the investment essentially takes place in sectors like manufacturing,
infrastructure and services.

Impact of FDI

Impact of FDI can be felt on a number of areas and it varies depending upon the
nature of the projects and the degree of integration with the rest of the economy.

Impact of FDI: Performance of FDI-Companies in India:

The Reserve Banks regular surveys on Foreign Collaboration in Indian
Industry, provide valuable information on the status of industries which are having
foreign collaboration. The latest survey (the sixth in the series) pertains to the period
1986-87 to 1993-94 and it covered 1,108 companies in the private sector (132
subsidiaries, 572 minority capital participation companies and 404 purely technical
collaboration companies). Major relevant findings of the survey are:
i. There was significant concentration of foreign capital in the manufacturing sectors
like chemicals and chemical products, machinery and machine tools, electrical
machinery and apparatus and transport equipment.
ii. As compared with the previous survey period (1981-86), there has been an
improvement in the profitability of the companies during 1986-87 to 1993-94,
especially in case of companies with minority capital participation and pure technical
collaborations.
iii. Production of the surveyed companies rose at an average annual rate of 20.3 per cent;
the leading contributors to production were chemicals and chemical products,
transport equipment, machinery and machine tools and the diversified groups.
iv. During the survey period (1986-87 to 1993-94), on an average, exports accounted for
63.3 per cent of imports by the companies; trade deficit was more pronounced in the
case of pure technical collaboration companies.
v. Import intensity of production increased during the survey period; value of imports
formed 11.6 per cent of total production of technical collaboration companies, 11.5
per cent production of minority capital participation companies and 8.6 per cent in
case of subsidiaries.
vi. Dividend remittance was high in case of chemicals and chemical products, followed
by machinery and machine tools (Reserve Bank, 1999).

IV
TOWARDS A REALISTIC FDI POLICY

If history is any guide, foreign investment in infrastructure is potentially

problematic. Latin America witnessed a wave of foreign infrastructure in investment
from the US in the 1930s, only to leave with the bitter experience of nationalisations
in a couple of decades. It bears repetition that infrastructure is inherently capital-
intensive with long gestation lags, and low (but stable) returns over a long period.
Market failures are ubiquitous in these industries, with considerable network
economies necessarily inviting wide and deep state intervention. In a world consisting
of politically independent nations with a growing number of democracies, the pricing
of infrastructure is bound to be a political decision. Foreign firms with short pay-back
periods invariably, find it hard to stay on, as it conflicts with the goals of developing
economies caught in an increasingly uncertain world economy.
There are also perhaps some India specific factors for the relatively small foreign
capital inflow. It seems worth reiterating that India is still largely an agrarian
economy, with land productivity being a third of Chinas, where the average
disposable income after meeting food and clothing (wage goods) requirement is still
relatively small. Price-income ratio of most consumer goods that foreign firms usually
sell is high by domestic standards, accentuated perhaps by cultural factors and
regional heterogeneity of markets (Financial Times, April 25, 2002).
In infrastructure industries, the rupee cost of electricity supply by foreign firms
seems high. Given Indias fairly diversified industrial capability, and low labour costs,
foreign firms may not have a cost advantage over the domestic producersespecially
with the currency depreciating in nominal terms. This is perhaps best illustrated,
again, by the Enrons DPC. With imported capital goods and fuel, and high operating
cost due to international norms of costing, Enrons cost of production was found to be
higher than the comparable new plants using domestic capital equipment (Morris,
1996).
At the same time, Hyundais large investment with consciously built-in high
domestic content secured through economies of scale has succeeded in producing a
small car that seems competitive both in price and quality. Reportedly, Hyundai
proposes to use its Indian plant as a global hub for its small car (The Economic Times,
January 2, 2003). Thus, the key to increasing FDI inflow seems to lie in industries
(and products) with relatively high technology that has large economies of scale, with
substantial domestic content.
 However, the foregoing reasoning still does not explain why foreign investment
does not come to use cheap labour and skills for export of labour-intensive
manufacturesas it has happened in China. We are inclined to believe that the foreign
investment policy lacks a clear focus. Unlike China, India has not invested in export
infrastructure. In fact, as is widely accepted now, the share of infrastructure in fixed
capital formation has declined sharply for nearly one and half decade now (Nagaraj,
1997). Further, what is needed is not perhaps large investment but suitable
inducement to international marketerstrading houses and retail chainsto set up
purchase offices and testing facilities to tap the potential of the domestic
manufacturers. It is widely acknowledged that Chinas export success largely lies in
marrying its low-cost manufacturing capability in Town and Village Enterprises
(TVEs) with Hong Kongs highly developed trading houses and other long-
established commercial organisations catering to international trade. While it is out of
question for India to replicate the location and historical advantage of Hong-Kong for
China, investment in export infrastructure in strategic locations and carefully tailored
incentives to international trading houses (and retailers) merit a serious consideration.
Similarly, such investments are perhaps equally necessary to tap the growing potential
for using Indias labour cost advantage for doing back office jobsbusiness processes
outsourcingfor international firms (The Economist, May 5, 2001).
Realistically, what is it that India expects from foreign investment, and how to
secure it? In principle, openness to foreign investment should be strategic, not passive
(or unilateral). History does not seem to support such an uncritical international
integration as a proven route to growth and efficiency. If the recent experience is any
guide, foreign capital is far from a major provider of external savings for rapid
industrialisation of any large economy. It can only supplement the domestic resources,
wherever they necessarily come bundled with technology and access to international
production and distribution networks. The terms of foreign investment will depend on
the relative bargaining power of the foreign firm vis--vis domestic firms, backed by
the state. Indian advantages are the availability of the skilled workforce, cheap labour,
and the size of the domestic market, which it should leverage as most successful
countries have done. A telling instance of it is perhaps Koreas big leap in
semiconductor and telecom equipment manufacturing in the recent years, as it seems
to have tied liberalisation of domestic market to sharing of production technology.
If this view has any value, then how should we go about inviting FDI that is
consistent with the economys long-term interests? Foreign investment should be
allowed mainly in manufacturing to acquire technology, and to establish international
trading channels for promoting labour-intensive exports.

V
SUMMARY AND CONCLUSION

Ending is long held restrictive foreign investment policy in 1991, India sought to
compete with the successful Asian economies to get a greater share of the worlds
FDI. Cumulative approved foreign investment since then is about $67bn, but the
realised amount is about a third of itthe ratio roughly comparable to Chinas. While
the foreign investment inflow represents a substantial jump over the 1980s, it is
modest compared to many rapidly growing Asian economies, and minuscule
compared to China. While the bulk of the approved FDI is for infrastructure, the
realised investment is largely in manufacture of consumer durable goods and the
automotive industry seeking Indias seemingly large and growing domestic market.
Foreign investment in telecom and software industries has also been significant.
Approved FDI has largely gone to a few developed statessimilar to its
concentration in the southern coastal provinces in China. A sizable part of the foreign
investment seems to represent a gradual increase in foreign firms equity holding
(hence managerial control) in the existing firms, and acquisition of industrial assets
(and brand names).
Chinas ability to attract a phenomenal amount of foreign investment is a puzzle
for many. About 40-40 per cent of Chinas FDI represents its domestic saving
recycled as foreign investment via Hong Kong to take advantage of economic
incentives---popularly called the round tripping. Another 25 per cent or so, seems to
represent investment in real estate by overseas Chinese that is potentially problematic,
as such investments could easily give rise to property bubbles. Thus, the quantum of
foreign investment from the advanced economies that could improve domestic
production capability is perhaps not very different from that in India. In relation to its
domestic output. Contrary to the popular belief, Chinas foreign investment regime is
said to be more restrictive than Indias. Therefore, what India should be concerned
about is not so much the absolute quantum of the inflow, but how effectively it uses
its external openness to augment the domestic capability, and access foreign markets
for its labour-intensive manufactures.
As the 1990s experience shows, quite contrary to the popular perception, the size
of Indias domestic market is relatively small, given the low levels of per capita
income. After meeting the needs of food and clothing (wage goods), income left for
spending on products that most foreign firms offer seems small; their price-income
ratio too high for Indian consumers. Therefore, many of them seem to be making
efforts to indigenise production to reduce costs and secure economies of scale. In this
process, many foreign firms are discovering the potential of low cost of ma
manufacturing for exports.
Much of the approved FDI in infrastructure did not fructify, as the rupee cost of
electricity supply by foreign firms is too much high for Indian consumers. This seems
true for two reasons: one, prices of goods like electricity are widely subsidised, and
cannot be increased without inviting public opposition; second, India produces much
of these services at lower cost using domestic raw material and capital equipment.
Foreign investment in consumer goods industries has increased domestic
competition, resulting in greater choice and quality improvement. While FDI inflow
displaced some domestic firms (and brand name), the bulk of them haveat least yet
largely been able to withstand the competition by making large capital investment,
and in expanding distribution networks.
What should be done to increase foreign investment? It is popularly believed that
a more liberal policy regime, industrial labour market reforms, and infrastructure
investment are needed. While infrastructure improvement surely merits a close
attention, one is not so sure if the extent of the reforms and the quantum of foreign
investment inflow are positively related. Moreover, there is little evidence that greater
FDI inflow ensures faster output and export growth. Such simplistic associations,
usually based on cross-country analysis, seem to have support neither in principle nor
in comparative experience.
What is needed is a strategic view of foreign investment as a means of enhancing
domestic production and technological capability, and so also to access the external
market for labour-intensive manufacturesas China has precisely done. It seems
valuable to reiterate what K.N. Raj, a perceptive observer of comparative economic
development, noted early in Chinas liberalisation drive. It is certainly not without
good reason that China has chosen to be hospitable even to multinationals with
worldwide ramifications like IBM, evidently in the expectation of securing the know-
how for building up semi-conductor industry of its own. Those who do not realise the
implications of all this for India are living in a dream of their own (Raj, 1985).
Such interventions need selectively, and strategic intent. Comparative experience
seems to clearly favour such a policy stance.

21
Services in the Indian Growth Process

THE phenomenal expansion of services world-wide led to services being regarded

as an engine of the growth even as a necessary concomitant of economic growth.
Development economics suggests that development is a three-stage process. The
dominance of the services sector in the growth process is usually associated with the
third stage of growth. During the 1980s and 1990s, services accounted for a share of
about 70 per cent of GDP in industrialised countries and about 50 per cent in
developing countries.
In India growth of services picked up in the 1980s, and accelerated in the 1990s,
when it averaged 7.5 per cent per annum, thus providing an impetus to industry and
agriculture, which grew on average by 5.8 per cent and 3.1 per cent respectively?
Growth in the services sector has also been less cyclical and more stable than the
growth of industry and agriculture (in the sense of having the smallest coefficient of
variation).
TABLE- 21.1

Sectoral Growth Rates

Average growth (In per cent per annum)

1951-1980 1981- 1991-

1990 2000

Agriculture 2.1 4.4 3.1

Industry 5.3 6.8 5.8

Services 4.5 6.6 7.5

GDP 3.5 5.8 5.8

Source: Gordon and Gupta, 2003

A notable feature of the structural transformation of the services sector has been
the growth of skill intensive and high value added sectors, i.e., software,
communication and financial services. The rapid growth of services can be attributed,
inter alia, to the advent of information technology (IT) and the knowledge economy.
This has enhanced the growth of the high productivity segment of the services sector
as well as variety of service activities involving low productivity activities catering to
a large mass of people. The phenomenal growth of low skilled service activities has
occurred due to reduced opportunities in the manufacturing sector, particularly in the
unorganised sectors.
Some of the activities in the service sector are multidimensional, being part of
industry as well as services, such as information technology and construction. Service
statistics in most countries including India provide information on value-addition of
various activities of business services, hotels, trade, financial services, etc. For an
empirical analysis, sub-sectors including trade, transport and communication,
financing, insurance, real estate and business services can be categorised as producer
services with hotels and restaurants and other services as consumer services.
Government services comprise public administration and defence services. During
1999-2000, producer services accounted for about 70 per cent of the total services
followed by consumer services (17 per cent) and government services (13 per cent).
The high share of producer services reflects the strong inter-linkages between services
and goods producing sectors of the economy.
The emergence of services as the most dynamic sector in the Indian economy has
in many ways been a revolution. The most visible and well-known dimension of the
take-off in services has been in software and IT-enabled services (including call
centres, design, and business process outsourcing). However, growth in services in
India has been much more broad-based than IT. In fact, although, IT exports have led
a profound impact on the balance of payments, the sector remains a small component
of GDP. As of 2001, business services (which include IT) contributed only about 1 per
cent of GDP, or 1/50 to the size of total services output (Table 21.1).
Rapid growth of the service sector is not unique to India. The existing literature
shows that as an economy matures the share of services in output increases
consistently. To begin with, the increase occurs along with an increase in the share of
industry. Thereafter, the service share grows more rapidly, accompanied by a stagnant
or declining share of the industrial sector. Cross-country experience suggests that the
first stage occurs until the country reaches lower middle income status, while the
second stage commences once it becomes an upper middle income country.
Consistent with the trend observed in other countries, Indias growth experience
has been characterised by a decline in the share of agriculture in GDP and an increase
in the share of industry and services. Between 1951 and 2000, the share of agriculture
in GDP fell from 58 to 25 per cent, while the share of industry and the share of
services increased from 15 to 27 per cent and from 27 to 48 per cent, respectively. In
the 1990s, however, the share of services in Indias GDP climbed by about 8
percentage points, as compared to a cumulative increase of 13 percentage points
during 1951-1990. The share of the industrial sector, on the other hand, has been
stagnant since the 1990s. As a result, the sectoral composition of output in India has
come to resemble that of a middle-income country, even though its per capita income
remains that of a low-income country.

Growth and Sectoral Shares, Cross Country Evidence and Indian

Experience

The evolution of sectoral shares in output, consumption and employment as

economies grow has been studied by economists for well over fifty years. During the
1950s and 1960s, research by Kuznets and Chenery suggested that development
would be associated with a sharp decline in the proportion of GDP generated by the
primary sector, counterbalanced by a significant increase in industry, and by a more
modest increase in the service sector. Sectoral shares in employment were predicted to
follow a similar pattern.
With the benefit of more data on development than was available to Kuznets and
Chenery, recent literature has tended to emphasise the growing importance of service
sector activity (Inman 1985, Kongsamut, Rebelo and Xie, 2001). For example,
Kongsamut, et al, (2001) analyse a sample of 123 countries for 1970-1989 and show
that rising per-capita GDP is associated with an increase in services and a decline in
agriculture both in terms of share in GDP and employment. In other words, the
sectoral share given up agriculture as the economy matures goes more to the services
sector and less to industry than the Kuznets-Chenery work had suggested. The
modern view is that as an economy matures, the share of services (in output,
consumption, and employment) grows along with a decline in agriculture. By
contrast, the share of industry first increases modestly, and then stabilises or declines.
(Gordon and Gupta, 2003)

Share of Services in GDP:

Such a pattern of growth is visible in the cross-country data on shares in GDP
(Table 21.2). These data suggest two stages of development. In the first, both industry
and services shares increase as countries move from low income to lower middle
income status, while in the second, the share of industry and that of services increases
as the economy moves to upper middle and higher income levels.
TABLE 21.2

Sectoral Shares in GDP in 2001, Global Averages (Per cent of GDP)

Agriculture Industry Services

Low Income 24 32 45 Stage I

Lower middle income 12 40 48

Upper middle income 7 33 60 Stage II

High income 2 29 70

Source: World Banks WDI,2003, Table 4.2. Definition: Low income: per capita GDP<$745;
Lower middle-$746-2975; Upper middle-$2976-9205; and high > $9206

How does the Indian experience fit in with this patter? In the four-decade period,
1950-1990, agricultures share in GDP declined by about 25 percentage points, while
industry and services gained equally. The share of industry has stabilised since 1990,
and the entire subsequent decline in the share of agriculture has been picked up by the
services sector. Thus, while over the four decades, 1950=1990, the services sector
gained a 13 per cent share, the gain in the 1990s alone was 8 percentage points.
Consequently, at current levels, Indias services share of GDP is higher than the
average for other low income countries.
According to Gordon and Gupta, if different sectors in India grow at the average
growth rates experienced in 1996-2000, then by 2010, the share of services would
increase to 58 per cent, which would bring the size of the Indias services sector,
relative to GDP, closer to that of an upper middle income country, while still
belonging to the low-income group.

TABLE- 21.3

India, Sectoral Shares in GDP, 1950-2006

(Per Cent of GDP)
 Agriculture Industry Services

1950 58 15 28

1980 38 24 38 Stage I

1990 33 27 41

2000 24 27 49 Stage II

2003-04 22 26 53

2004-05 (P) 20 26 54

2005-6 (Q) 20 26 54

2006-07 (R) 19 27 55

Source: Central Statistical Organisation

Share of Services in Employment:

Even though India has experienced profound changes in output shares, the same is
not true for employment shares (Table 21.4). A striking feature of Indias development
is that in contrast to the substantial decline in the share of agriculture in GDP, there
has been rather little change in the share of employment in agriculture (Bhattacharya
and Mitra, 1990). Similarly, although services rose from 42 per cent of GDP during
the 1990s, the employment share of services actually declined by about one
percentage point during the decade. Thus, while activity has shifted to services,
employment creation in services has lagged far behind.
Indias relatively jobless service sector growth is unlike the experience of other
countries, where the service sector has tended to gain a larger share of employment
over time. When compared with other countries India has an exceptionally large share
of services employment.
TABLE 21.4

India, Share of Service Sector in Employment and Capital Formation (In per cent of total)

Employment Gross Capital Formation

1965-66 18.1 46.1

1970-71 20.0 43.7

1980-81 18.9 44.0

1990-91 24.4 41.2

1999-2000 23.5 39.6

Source: Hansda (2002)

Which Services Have Grown Rapidly?

 The acceleration in services growth in the 1980s and 1990s was not uniform
across different activities (Table 21.5). Some segments grew at a rate much faster than
their past average growth rates, while for other sub-sectors, growth rates were similar
to the past trend. To identify the growth-drivers within the services sector, Gordon and
Gupta have compared the growth rates of various activities in the 1990s with their
previous trend growth rates. The trend growth rates have been estimated using the
three-year moving average of the rate and the period through 1990 is included in
estimating the trend (except for banking for which the trend is estimated using the
data until 1980).
Comparison of the actual and the trend growth rates shows that growth in several
service sub-sectors accelerated sharply in the 1990s (and 1980s for banking);
indicating some sort of a structural break in their growth series. According to Gordon
and Gupta these activities are fast growers. The remaining grew more or less at a
trend rate, these they call trend growers.
Based on the above criterion, fast growers include business services (which
include IT), communication services, and trade (distribution) services. The trend
growers include real estate, legal services, transport, storage, personal services, and
public administration and defence (PAD).

Fast Growers:
Business services were the fastest growing sector in the 1990s, with growth
averaging nearly 20 per cent a year. Though disaggregated data for this category are
not available, however export and software industry data show that the growth was
mainly on account of the IT sector. Despite being the fastest growing sector, business
services, particularly IT activity, was growing off a low base and its contribution to
service sector and GDP growth was quite modest in the nineties. This segment is
expected to continue growing at a very high rate and is likely to contribute more
significantly to services growth in the future.
Communication services, which registered growth of 14 per cent a year during the
1990s, made a significant contribution to services growth. The growth in
communication was mostly due to telecom, which accounts for 80 per cent of output
and grew at 17 per cent a year on average during the 1990s.
In the banking sector, growth jumped from about 7 per cent over the period 1950-
1980, to 12 per cent in the 1980s, and to 13 per cent in the 1990s. Growth was most
rapid in NBFIs (which grew by 24 per cent in the 1980s and 19 per cent in the 1990s),
followed by growth in the banks (10 per cent and 9 per cent respectively in the 1980s
and 1990s). The contribution of banking services sector growth was larger than that of
the communication sector.
Community services and hotels and restaurants increased at the trend growth rate
through the early 1990s, and a pick-up in growth in the latter part of the decade. In
community services, this was due to both education and health services (accounting
for about 70 per cent and 23 per cent of the value added, respectively) growing at an
average rate of 8 per cent in 1990s.

Trend Growers:
The growth rate of distribution services (the largest service subsector in India),
averaged about 6 per cent in the 1980s, higher than in previous decades, and
accelerated further to about 7 per cent in the 1990s. This sub-sector qualifies as a
trend grower. While growth of distribution services picked up strongly in the second
half of the 1990s, growth was not much above trend for the decade as a whole.
 The rate of growth of PAD in the 1990s averaged 6 per cent, which was similar to
the growth experienced in previous decades. Growth spiked upwards in response to
the Fifth Pay Commission awards to government employees in the late 1990s, but this
did not shift average PAD growth upwards for the decade as a whole. Acharya
(2002a) estimates that imperfect deflation of the Fifth Pay Commission in the
National Accounts led to an overstatement of the growth of government services
(PAD) in the late 1990s. Hansda (2002) and RBI (2002) concede that there may have
been some upward distortion in the estimates for a few years as a result of the Pay
Commission, but note that it was not of sufficient magnitude to affect the trend in
services growth, which increased in the 1990s, even if PAD is excluded altogether.
The growth rate of personal services almost doubled in the 1990s, as compared to
the 1990s, but at 5 per cent average it remained below the growth in most of the
service activities. As a result, personal services declined as a percentage of GDP
through the 1990s. The other sub-sectors such as transport, dwellings, and storage did
not grow more rapidly than the average of the previous decades in either the 1980s or
1990s.

Contribution of Fast and Trend Growers to Services Growth:

The fast-growing activities accounted for about a quarter of services output in the
1980s, but because of their relatively fast growth, these activities represented one-
third of these services output by 2000. (Gordon and Gupta, 2003)
The high services growth in the 1980s was primarily due to the trend growing sub-
sectors (these activities added about 1 percentage point of extra growth in the 1980s),
while the contribution made by the fast growing activities was only about half the
size. In the 1990s, by contrast, fast growing activities made about the same
contribution to services growth as the trend growing sectors. In fact, since the trend
growing sectors grew at about the same rate in both decades, the fast growers
collectively accounted for almost all of the higher growth in the 1990s. This is
consistent with new activities and industries having sprung up in the fast growth sub-
sectors, but not in the trend growth ones. (Gordon and Gupta, 2003)

Factors Underlying the Services Growth

What are the factors behind the dynamism of the services sector in India. One
explanation suggested in the literature for fast growth in services is that the income
elasticity of demand for services is greater than one. Hence, the final demand for
services grows faster than the demand and commodities as income rises.
A rising share of services in GDP is regarded as an outcome of higher income
elasticity of demand services. The empirical studies have shown that the income
elasticity of demand for services could be greater than or equal to unity (Gemmell,
1982; Summers, 1985; Bergstand, 1991; Falvey and Gemmell, 1991). Income
elasticity of demand for services increases with rising income which favours the
fulfilment of more sophisticated desires. During the development process, distribution
of GDP and employment register sectoral shifts. Such shifts may occur on account of
the hierarchy of needs, distinguished into basic needs for food and shelter and needs
for other material and non-material goods including services (Maslow, 1970).
According to this view, income elasticity of demand depends on per capita income
and differs across various sectors.
The empirical estimates of price and income elasticity for various categories of
services in India are summarised in Table 21.6. it is important to mention that the
actual behaviour of the services sector in real GDP depends on the relative strength of
the coefficients of the income and price elasticity.
TABLE 21.6

Income and Price Elasticities for the Services Sector

Sector Income Elasticity Price Elasticity

1 2 3

Services 1.20* -0.68*

Producer Services 1.22* -0.78*

Consumer Services 1.00* -0.10

Government Services 1.41* -1.05*

Note: *: Statistically significant at 1 per cent

The income elasticity of demand is greater than unity and price elasticity is
negative and significant for the total services, produces services and government
services. In other words, demand for overall services rises with increase in per capita
GDP and decreases with increase in prices of services. The higher income elasticity of
demand in the case of producer services underscores its forward linkages. This is
corroborated by the emergence of producer services comprising advertising, publicity,
marketing and other IT-related activities in the recent period as important service
industries in India. Therefore, producer services can be regarded as a major source of
economic growth.
Another explanation is that technical and structural changes in an economy make
it more efficient to contract out services that were once produced in the industry. This
type of outsourcing has been called the splintering of industrial activity. Splintering
results in an increase in net input demand for services from the industrial sector, as
well as the services sector growing proportionately faster than other sectors.
The empirical evidence presented in Gordon and Gupta (2003) shows that while
splintering and high income elasticity of demand for services have served to stimulate
services growth in India, it is necessary to look beyond these factors to fully explain
the growth acceleration since the 1990s. In particular, important roles also seem to
have been played by economic reforms, the advent of the IT era, and growing external
demand for services exports. Industrial sector reforms have also been carried out in
India and the question arises why the industrial sector has not experienced the same
sustained high level of growth that the service sector has experienced. This could be
because industrial growth is more dependent on infrastructure development (such as
roads and ports), which have acted as bottleneck to growth. Labour restrictions and
small-scale reservations may also have disadvantaged industry more than services. In
addition, the faster growing services activities seem to be more intensive in skilled
labour, with which India is well endowed.
A number of studies have attempted to explain the fast growth in the share of
service activity observed in cross country data. The literature draws a distinction
between demand and supply factors.
On the supply side, the share of services can be boosted by a switch to a more
service-input intensive method of organizing production. Such a change in production
methods can arise as a result of increasing specialization as the economy matures. For
example, over time, industrial firms may make greater use of specialist sub-
contractors to provide services that were previously provided by the firms themselves.
Legal, accounting, a security services are obvious candidates to be contracted out.
Bhagwati (1994) calls this process of specialization splintering. Kravis (1982) points
out that splintering will lead to growth in the share of services in GDP, even when
GDP itself is not growing.
On the demand side, an increase in the output share of services can arise from
rapid growth in the demand for services. This could be from domestic consumers with
a high-income elasticity of demand for services, or from foreign consumers with a
growing demand for the countrys service exports. Demand-led growth of this type is
likely to result, at least initially, in higher prices of services, as well as a shift of
resources into the production of services.
With the advent of the IT revolution, it has become possible to deliver services
over long distances at a reasonable cost, thus trade in services has increased world-
wide. India has been a particular beneficiary of this trend. In India, the exports in
services (in dollar) grew in average at 15 per cent a year in the 1990s, compared with
9 per cent in the 1980s, and at 21 per cent a year in the second half of the 1990s.
Cumulatively, services exports increased four-fold in the 1990s and reached US$ 25
billion in 2002.
The increase in exports has been most dramatic in software and other business
services (included in the miscellaneous category), but there has also been growth in
the export of transport, and travel services. As a result, the composition of services
has changed dramatically in favour of miscellaneous services, which includes
software exports.
Service activity can also be stimulated by technological advances, whereby new
activities or products emerge as a result of technological breakthroughsuch
advances are likely to be particularly relevant in the case of the IT sector (e.g. the
internet), telecommunication (cellular phone services) and to some extent in financial
services (credit cards, ATM etc.).
Liberalisation can also provide a boost to services. In India, important policy
reforms were made in the 1990s which were conductive to the growth of services
sector, such as deregulation, privatisation and opening up to FDI. If the growth of
services was previously inhibited by government controls, then policy may provide a
positive shock that unleashes new activity and growth.
An example would be the telecom industry where inefficient government
provision led to a situation of effective rationing of services up until the early 1990s.
As seen earlier, communications has been one of the fastest growing services
subsectors in the 1990s and liberalisation undoubtedly a major role.
Thus, the set of economic reform measures initiated since 1991 also impacted on
the performance of the services sector. First, reforms in the domestic industrial
environment which resulted in rising manufacturing growth provided synergies to the
services sector in the form of increased demand for producer services. Second, the
liberalisation of the financial sector provided an environment for faster growth of the
financial services. Third, reforms in certain segments of infrastructure services also
contributed to the growth of services. Consequently, the services sector posted a much
higher growth during the reform period as compared with the pre-reform period with
its share touching nearly the 50 per cent mark.

External Demand for Services:

 The growing role of tradable services in international trade and exchange has
come to be recognised with the General Agreement on Trade in Services (GATS).
Indias share in world export of commercial services has doubled from 0.6 per cent in
1990 to 1.2 per cent in 2000, while the share in world merchandise exports has gone
up marginally from 0.5 per cent to 0.7 per cent during the same period. Interestingly,
there has been a consistent surplus on account of trade in services. The compositional
shifts in foreign trade in favour of services in the reform period have helped in the
emergence of new sources of earnings in Indias balance of payments. Earnings from
software exports have increased from negligible levels in early 1990s to a level of
US$ 7.5 billion in 2001-02. Thus, while the 1980s was dominated by tourism
earnings, the second half of 1990s witnessed an unprecedented jump in Indias
earnings from new economic activities like software services exports and other
information technology related skill intensive exports. The services exports thus,
provided some element of stability to the external balance of the country and also
positively impacted on the overall demand in the services sector.
Services exports during 2005-06 continued to be led by rapid growth in software
services exports, other business and professional services (Table 21.7). Within the
services exports, rising prominence of business services reflects high skill intensity of
the Indian workforce. There has also been a strong revival in international tourist
interest in India since 2003-04.

Structure of Indias Services Exports

TABLE 21.7

Structure of Indias Services Exports

Share in Total Services Exports (per cent)

Year Amount
(US $
million) Travel Transporta- Insur- G.N.I. Softwa Miscella-
tion ance E -re neous*

1 2 3 4 5 6 7 8

1970-71 292 16.8 49.7 5.5 13.7 - 14.4

1980-81 2,804 43.5 16.3 2.3 4.0 - 33.9

1990-91 4,551 32.0 21.6 2.4 0.3 - 43.6

2000-01 16,268 21.5 12.6 1.7 4.0 39.0 21.3

2003-04 26,868 18.7 11.9 1.6 0.9 47.6 19.2

2004-05 46,031 14.1 10.4 2.0 0.7 37.4 35.4

2005-06 60,610 12.9 10.4 1.7 0.5 38.9 35.6

Note *: Excluding software services

G.N.I.E: Government not included elsewhere
Source: RBI Annual Report 2005-06

Services Trade:
India has been recording high growth in the export of services during the last few
years. Such exports have increased threefold during the last three years; in 2005-06,
with a growth of 42.0 per cent, it reached US$ 61.4 billion. Growth has been
particularly rapid in the miscellaneous service category, which comprises of software
services, business services, financial services and communication services. In 2005,
while Indias share and ranking in world merchandise exports were 1 per cent and 29
respectively, its share and ranking in world commercial services exports was 2.3 per
cent and 11, respectively. By growing faster than merchandise exports, services
exports constituted almost 60 per cent of merchandise exports in 2005-06.
Reflecting these positive developments and continued buoyancy of Indias
services exports, the share of Indias services exports in world exports has recorded a
significant increase from 0.6 per cent in 1995 to 2.3 per cent in 2005. India was the
18th largest service exporter in the world in 2004 became no 11 in 2005. The gains
recorded by the exports have far exceeded those recorded by exports of goods.
Impressive growth in receipts from business services continued during 2005-06.,
indicating Indias rising advantage in commercial services. Earnings from exports of
software and IT-enabled services remained the key driver of services earnings during
2005-06, recording a growth of 33 per cent. Globally, India ranks second to Ireland in
exports of computer and information services. Notwithstanding increasing
competitive pressured, India remains an attractive source because of its low-cost
operations, high quality of products and services and availability of skilled manpower.
Favourable time zone difference also helps organisations run around the clock internal
operations and render better customer service. In order to withstand growing global
competition, the Indian IT companies have started moving up the value chain by
exploring untapped potential in IT consulting and system integration, hardware
support and installation and processing services.
The enormous opportunities for further growth of these services make WTO
negotiations in services all the more important for India (Box 21.1).
While India is negotiating for greater market access in developed country markets,
domestic regulations create barriers for Indian service providers even when trading
partners have taken firm commitments. Quick domestic policy reforms are needed,
especially in qualification and licensing requirements and procedures, to impart
effective market access for our service providers. Some of the ways of promoting
services could include facilitation to become known suppliers of quality services,
providing relevant export market information, providing appropriate export financing
with reduced transaction costs by reviewing the common practice of collateral
backing, good marketing of services by energizing Indian embassies and industry
associations, anchoring brand ambassadors for promoting services, and leveraging the
countrys potential services purchasing power in multilateral and bilateral negotiations
and in the CECAs.
 BOX- 21.1

Services, GATS and Strategies for India

Services account for more than 60 per cent of world GDP, and trade in services has grown
more rapidly than merchandise trade since 1985. In 2004, while Indias share in world
merchandise exports was 0.8 per cent, the corresponding share in world commercial services
was 1.9 per cent. Services, accounting for 54.1 per cent of GDP in 2005-06, are a sector of
critical interest in India.
In the ongoing negotiations at WTO under the General Agreement on Trade in Services
(GATS), the offers of most countries do not provide any significant new openings for trade,
especially in areas of interest for developing countries. Given its strong competitive edge in IT
and ITES, and competence of its professionals, Indias efforts have been to get binding
commitments in cross-border supply of services (Mode 1) and movement of natural persons
(Mode 4). In mode 4, India has been pushing for clear prescription of the duration of stay and
removal of the Economic Needs Test (ENT). Though the services negotiations have been
salvaged at the Hong Kong Ministerial, quick and detailed work id needed in the form of
examining the detailed requests and offers and arriving at concrete proposals in each of the 12
main categories and 156 sub-categories of services.
Besides software in which India has already made an impact, there is good potential for
export of many other professional services, like super-speciality hospital; satellite mapping;
printing and publishing; accounting, auditing and book-keeping services. Besides greater
efforts at marketing, there is a need to negotiate both multilaterally and bilaterally, issues like
the National Health Service Systems in European countries like UK which virtually deny
market access; lack of coverage of medical expenditure incurred abroad by US medical
insurance companies; need based quantitative limits; need to be natural persons; and
accreditation rules. Similarly, in the case of accounting, auditing and book-keeping services,
market access limitations, which are mainly in the form of licensing, accreditation, in-state
residency and state level restrictions in countries like US, have to be negotiated. Some liberal
sectoral commitments by developed countries get automatically negated by the restrictive
horizontal limitations of entry for speciality occupations which needs to be addressed in WTO
negotiations.

Source: Economic Survey 2005-06

Summing Up

The services sector has exhibited a strong trend component that has provided an
element of stability to the growth process. The sector seems to have grown in the
reform period, sustained by an increasing demand for producer and consumer services
coupled with the external demand. The role of public administration and defence
appears to have been limited in the growth process. The emergence of producer
services as an important source of services growth reflects strong interlinkage with
commodity producing sectors of the economy. Apart from providing inputs, services
contribute to the outward shift of the industrial sectors production frontier by
enhancing productivity growth. Conversely, services growth could be sustained
provided adequate demand impulses are generated in industry or agriculture. Given
Indias comparative advantage in information technology, services growth momentum
can be sustained by exploiting new opportunities in international trade in services,
particularly, in the area of communication and information services, technology
transfer and software.
 Gordon and Gupta (2003) suggest a bright future for the Indian services sector.
The effects of high income elasticity of demand and increased input usage in industry
are likely to continue for some time, before tapering off. But extra impetus to services
growth is also likely to come from exports and from liberalisation. New markets for
Indian service exports are just beginning to be tapped and there is substantial scope
for considerable growth from liberalisation and the associated productivity gains in
some of the services subsectors where growth has lagged behind in the 1990s.

22

The Financial Sector

Structure, Performance and Reforms

THE financial sector plays a major role in the mobilisation and allocation of
savings. Financial institutions, instruments and markets which constitute the financial
sector act as a conduit for the transfer of financial resources from net savers to net
borrowers, i.e., from those who spend less than they earn to those who earn less than
they spend. The gains to the real sector, therefore, depend on how efficiently the
financial sector performs this function of intermediation.

Financial Sector Development in India

The Indian financial sector today comprises an impressive network of banks and
financial institutions and a wide range of financial instruments.

Institutional Structure:
At present, the institutional structure of the financial system is characterised by (a)
banks, either owned by the government, RBI, or the private sector (domestic or
foreign) and regulated by the RBI; (b) development financial institutions and
refinancing institutions, set up by a separate statute or owned by the Government,
RBI, private, or other development financial institutions under the Companies Act and
regulated by the RBI; and (c) non-bank financial companies (NBFCs), owned
privately and regulated by the RBI.
Provision of short-term credit is entrusted primarily to commercial and
cooperative banks. Of late, commercial banks have diversified into several new areas
of business such as merchant banking, mutual funds, leasing, venture capital,
factoring and other financial services. In addition, there is a wide network of
cooperative banks and cooperative land development banks at state, district and sub
district levels. Together, commercial and cooperative banks hold around two-thirds of
the total assets of the Indian system (Rangarajan and Jadhav, 1992).
Medium-term and long-term finance is provided primarily by a few large all India
development banks together with a spectrum of state level financial institutions.
While the Industrial Development Bank of India (IDBI), the National Bank for
Agriculture and Rural Development (NABARD), the Export-Import Bank of India
(EXIM Bank) and the National Housing Bank (NHB) serve as apex agencies in their
respective areas of concern, there are also other financial institutions which specialise
in areas like tourism and the small-scale industry.
 Besides these, there are investment institutions, which include the Unit Trust of
India (UTI), the Life Insurance Corporation (LIC) and the General Insurance
Corporation (GIC). In recent years, a number of public sector mutual funds have been
set up by banks and financial institutions. In addition, a large number of private sector
non-bank financial companies undertake Para-banking activity mainly in the area of
hire-purchase and leasing.
The capital market has witnessed a remarkable growth in the paid-up capital of
listed companies and market capitalisation in recent years. With a network of 23 stock
exchanges and as many as 9,413 listed companies in 2003, it has emerged as one of
the important markets in the developing world. The Securities and Exchange Board of
India (SEBI) has been established to regularise the capital market.

Capital Markets:
The 1990s have been remarkable for the Indian equity market. The market has
grown exponentially in terms of resource mobilisation, number of stock exchanges,
and number of listed stocks, market capitalisation, trading volumes, turn over and
investors base (Table 22.1). Along with this growth, the profile of the investors,
issuers and intermediaries have changed significantly. The market has witnessed a
fundamental institutional change resulting in drastic reduction in transaction costs and
significant improvement in efficiency, transparency and safety (NSE, 2002). In the
1990s, reform measures initiated by SEBI, market determined allocation of resources,
rolling settlement, sophisticated risk management and derivatives trading have greatly
improve the framework and efficiency of trading and settlement.
Almost all equity settlements take place at the depository. As a result, the Indian
capital market has become qualitatively comparable to many developed and emerging
markets.
TABLE- 22.1

Select Stock Market Indicators in India Year

(end-March) 1961* 1971* 1980* 1991 2000 2002 2003

7 8 9 22 23 23 23
Number of Stock Exchanges
Number of listed companies
1,203 1,599 2,265 6,229 9,871 9,871 9,413

Market Capitalisation 1,200 2,700 6,800 1,10,27 11,92,630 7,49,248 6,31,921

(Rs. Crore) 9

Note: *: end-December, BSE only.

Sources: The Stock Exchange, Mumbai and National Stock Exchange.
Rakesh Mohan (2004), Economic Development in India, vol. 74, Academic Foundation, New Delhi

Although the Indian capital market has grown in size and depth in the post-reform
period, the magnitude of activities is still negligible compared to those prevalent
internationally. India accounted for 0.40 per cent in terms of market capitalisation and
0.59 in terms of global turnover in the equity market in 2001. The liberalisation and
consequent reform measures have drawn attention of foreign investors and led to rise
in the FIIs investment in India. During the first half of the 1990s, India accounted for
a large volume of international equity issues than any other emerging market (IMF
Survey, 1995). Presently, there are nearly 500 registered FIIs in India, which include
asset management companies, pension funds, investment trusts and incorporated
institutional portfolio managers. FIIs are eligible to invest in listed as well as unlisted
securities.
The short-term money market which has links with the entire spectrum of the
financial system comprises five segments:
The call money market,
The inter-bank term deposit market,
The bills re-discount market, and
The Treasury bill market
The inter-corporate funds market
In recent years, new money market instruments such as Certificates of Deposits
(CDs), Commercial Paper (CP) and 182 days treasury bills have been introduced so as
to impart liquidity and depth to the money market. Moreover, a specialised money
market institution, named the Discount and Finance House of India (DFHI), has been
established with the objective of providing liquidity to money market instruments,
thereby helping to develop an active secondary market.

Strategy of Development:
The role of central banking and financial system in the process of economic
development was recognised at an early stage. The first Five Year Plan stated that:
Central banking in a planned economy can hardly be confined to the regulation
of overall supply of credit or to somewhat negative regulation of the flow of bank
credit. It would have to take on a direct and active role, firstly in creating or helping to
create the machinery needed for financing developmental activities all over the
country and secondly, ensuring that the finances available flow in the directions
intended.
During the 1950s and 1960s, the major concern was to create the necessary
legislative framework to relate reorganisation and consolidation of the banking
system. The year 1969 was a major turning point in the Indian Financial System when
14 large commercial banks were nationalised. The main objectives of bank
nationalisation were:
Re-orientation of credit flows so as to benefit the hitherto neglected sector
such as agriculture, small-scale industries and small borrowings.
Widening of branch network of banks, particularly in the rural and semi-
urban areas.
Greater mobilisation of savings through bank deposits.
Between June 1969 and March 1991, the total number of commercial bank offices
rose from 8,262 to as much as 60,570. The number of rural branches increased from
1,833 to 35,187 during the same period, accounting for 58.4 per cent of the total as
compared with barely 22 per cent in 1969. Accordingly, the average population served
per bank office declined from 64,000 in 1969 to about 14,000 in March 1991.
As a ratio of the GDP at current prices, bank deposits expanded during the period
from 16 per cent in 1969-70 to around 48 per cent in 1990-91, thus indicating the
banking industrys importance in the mobilisation of savings. In respect of advances,
the expansion during the same period was from 10 per cent o around 25 per cent of
the GDP, thus providing increasing support to expanding agricultural, industrial and
commercial activities.
The ratio of priority sector services (i.e. advances to agriculture, small-scale
industries and small borrowers) to net bank credit rose from 15 per cent in June 1969
to nearly 39.1 per cent in June 1991. The role of indigenous bankers and
moneylenders has declined considerably over the years. Studies based on surveys
indicate the dependence of rural households for cash debt from non-institutional
agencies has come down from about 93 per cent in 1950-51 to as low as 39 per cent in
1981. Thus, the benefits of banking are no longer confined to a narrow segment of the
population. Banking has acquired a broad base and has also emerged as an important
instrument of socioeconomic change. The other components of the financial system
such as the term lending institutions have also recorded a similar quantitative and
qualitative change.
TABLE 22.2

Progress of Commercial Banking in India

(Amount in Rs. Crore, Unless Mentioned Otherwise)

Indicators June June March March March March

1969 1980 1991 1995 2000 2003

1. No of commercial 73 154 272 284 298 292

banks
2. No of bank offices of 8,262 3,4594 60,570 64,234 67,868 68,561
which:
Rural and semi-urban 5,172 23,227 46,550 46,602 47,693 47,496
bank offices
3. Population per office 64 16 14 15 15 16
(000s)
4. Deposits of SCBs 4,646 40,436 2,01,199 3,86,859 8,51,593 12,80,853
5. Per Capita Deposit 88 738 2,368 4,242 8,542 12,253
(Rs.)
6. Credit of SCBs 3,599 25,078 1,21,865 2,11,560 4,54,069 7,29,214
7. Per capita Credit (Rs. ) 68 457 1,434 2,320 4,555 7,275
8. Share of Priority 15.0 37.0 39.2 33.7 35.4 33.7*
Sector Advances in
Total Non-Food Credit
of SCBs (per cent)
9. Deposits (per cent of 15.5 36.0 48.1 48.0 53.5 51.8*
national income)
Note: * : As at end-March 2002
Source: Reserve Bank of India

The mid-1980s saw some movement away from this regulated regime.
Commercial banks were permitted to enter new activities. Apart from the introduction
of new money market instruments, interest rates in the money market were freed from
control. Great flexibility was introduced in the administered structure of the interest
rate. While deposit rates were made attractive to savers by making the rate positive in
real terms, the structure of leading rates was simplified by linking the rate of interests
largely to the size if loans.
While the progress made by the financial system in general and the banking and
other financial facilities to a larger cross-section of the people and the country is well
recognised, there is a growing concern over the operational efficiency of the system.
There has been a perceptible decline in the productivity and profitability of
commercial banks. It is estimated that in 1989-90, gross profits before provisions
were no more than 1.10 per cent of working funds. In 1990, the spread between
interest paid and earned as a proportion of working funds in the same year was 2.05
per cent. With the decline in the quality of loan assets, (the sticky advances account
for more than 20 per cent of the credit outstanding) the need for provisioning has
become more urgent and several banks are not in a position to make adequate
provisions for doubtful debts. The financial position of the Regional Rural Banks is
far worse with the accumulated losses completely wiping out the capital in most
banks. The balance sheet of the performance of the financial sector is thus mixed,
strong in achieving certain socioeconomic goals and in general, widening the credit
coverage but weal as far as viability is concerned (Rangarajan and Jadhav, 1992).

Directions of Reforms

The financial markets in the industrially advanced countries have undergone far-
reaching changes in the 1980s. Innovations spurred by deregulation and liberalisation
have been a marked feature of this transformation. Rapid strides in technology in the
areas of telecommunication and electronic data processing have helped to speed the
changes. A major consequence of these changes is the blurring of the financial
frontiers in terms of instruments, institutions and markets. The distinction between
banks and non-banking financial institutions has become thin. Restrictions imposed
earlier on banks regarding the activities that they can undertake have been removed
one by one. Effectively, universal banking has now become the trend. Another feature
of the market is the interlinking of different national markets. With the dismantling of
exchange controls and the rapid developments in communication systems, funds have
started moving rapidly from one country to another.
It is the interlinking of different national markets which has come to be known as
globalisation. Important financial institutions are present in all the leading market
centres and markets are in operation on a 24 hour basis. Deregulation has thus meant
the dismantling of regulations relating to entry and expansion; it has also meant the
removal of all direct controls over interest rate wherever they existed. The integration
of markets, both financially and spatially, has led to a more unified market for the
allocation of savings and investment among the participating countries. The
functioning of the financial markets in the decade of 1980s has, however, raised some
serious concerns. There is a fear that the state of the financial markets is now
inherently more risky than in the past. In technologically integrated financial world,
the chances of systemic risk increase. The potential damage to the system arising out
of the failure of a large globally active banking or non-banking financial institution
can be immense. Because of the intense competition which banks have come to face,
both as a consequence of the growth of non-banking financial institutions as well as
securitisation, it is feared that the quality of the bank loans has suffered. With the
spectacular growth of non-bank financial institutions, the question of adequate
supervision of these institutions has also gained urgency. It is for these reasons that
increasing attention is paid in these countries towards evolving a common code of
prudential regulations applicable to all countries. Several significant steps have
already been taken in this direction. The new approach is somewhat loosely
summarised in the phrase with as much freedom as possible and with much
supervision as necessary (Rangarajan and Jadhav, 1992).
The issues in financial sector reform, as far as India is concerned, are in some
ways similar to the issues that have surfaced in the advanced countries. However,
there are concerns that are specific to the Indian situation. The ultimate objective of
financial sector reform in India should be to improve the operational and allocation
efficiency of the system. Even from the point of view of meeting some of the
socioeconomic concerns, it is necessary that the viability of the system is maintained.
It is in this context that a fresh look at the administered structure of interest rates is
called for. The reform of the Indian financial system must really begin here.
Administered Structure of Interest Rate:
The fundamental reason for introducing administered structure of interest rates in
our country is to provide funds to certain sectors at concessional rates. While there
may be ample justification for concessional credit to be provided to finance certain
activities, a highly regulated interest rate system has a number of weaknesses.
Government borrowing at concessional rate of interest has become possible only
because of the compulsion imposed on the financial institutions. This also results in
the monetisation of public debt if the Reserve Bank of India (RBI) is to pick up what
cannot be absorbed by banks and other institutions. Such restrictions, limit the ability
of these institutions to raise resources at market rates. In the case of credit to other
priority and preferred sectors, the burden of the financial institutions can be tolerable
so long as the quantum of such credit is limited, as there is a limit to cross-
subsidisation. The regulated interest rate structure has, therefore, implications for the
viability of the financial institutions. The reform of the interest rate structure is thuds
linked to the system of directed credit as it is practiced now.
In the case of commercial banks, directed credit takes the form of prescription of
Cash Reserve Requirement (CRR), statutory liquidity requirements (SLR) and the
allocation of credit for priority sectors. The CLR and SLR taken together now pre-
empt a significant proportion of the deposit liabilities. Banks are now required to
provide 40 per cent of net bank credit to priority sectors which include agriculture,
small-scale industry, etc. CRR has to be distinguished from SLR. The former is an
instrument of monetary control and its level has to be determined by monetary
authorities taking into account the overall economic situation. However, statutory
liquidity ratio is of a different character and has become basically an instrument for
providing credit to the government by the commercial banks.
In relation to direct credit for priority sectors the real problem is not so much the
proportion of credit allocated for priority sectors as much as the concessional rates of
interest enjoyed by the borrowers. Clearly there is a case for re-examination of those
who are entitled to borrow at concessional rates from the banking system. One
immediate way of doing this is to eliminate large borrowers from the credit to the
priority sector. No more than two concessional rates of interest should be prescribed
so as to keep the burden on the banking system within limits.
The financial system must clearly move towards an interest regime which is free
from direct controls. Obviously, interest rate is an important policy instrument.
Monetary authorities the world over try to influence the level of interest rate through
the various instruments that are available to them. It is not, therefore, argued that
monetary authorities should abdicate an important function of theirs. The general
level of interest rate should be influenced by the monetary authorities taking into
account the overall economic environment. The issue is whether a structure should be
imposed by the monetary authorities. In moving towards a more deregulated structure
of interest rate, there is considerable historical evidence to such experiments succeed
only when the inflationary pressures are under control. Sharp increase in nominal and
real rates of interest can result in adverse economic consequences. However, the
broad outlines of the reform agenda in terms of the interest rate as far as India is
concerned are quite clear. At least initially from an elaborate administered structure of
interest rate we should move towards a more simplified system where only a few rates
are determined (Rangarajan and Jadhav, 1992).
Autonomy, Prudential Regulations and Supervision:
Even as the external constraints such as administered structure of interest rate and
pre-empted credit are eased, the financial institutions must act as business units with
full autonomy and the same token become fully responsible for their performance.
There are instances of countries like France where the major banks are in the public
sector but are allowed to operate with a high degree of autonomy without any
interference from the government. In the Indian context, adverse selection and
moral hazard which have been discussed in recent literature arise more because of
outside interference with decision making than as a consequence of interest rate
policy. In fact, decisions such as waiver of loans also have an adverse effect on the
performance of financial institutions as they vitiate the recovery climate. In short, the
operational efficiency of the system will improve only if we restore functional
freedom to the financial institutions.
The need for stringent prudential regulations in a more deregulated environment
has become apparent in many countries. The elements of prudential regulation which
have assumed greater importance in the recent period relate to capital adequacy and
provisioning. The Indian system has so far been slack in relation to both these aspects.
Capital adequacy did not perhaps receive adequate emphasis because of the false
assumption that banks and financial institutions owned by the government cannot fail
or cannot run into problems.
With major Indian banks now having branches operating in important money
market centres of the world, this question can no longer be ignored. This apart, even
banks operating in domestically needs to build an adequate capital base. The Bank for
International Settlements ha prescribed the norm for capital efficiency at 8 per cent of
the risk weighted assets. As the Narasimham Committee (Government of India, 1991)
has recommended, banks which have a consistent record of profitability may be
allowed to tap the capital market for meeting this additional requirement. This would
involve a dilution of ownership which cannot be avoided and which may also serve a
useful purpose. What has been told about banks holds good in relation to term lending
institutions as well as other financial institutions. Whether they be leasing companies
or hire purchase companies or investment companies, prescription of appropriate
capital requirements is a must since capital is the last line of protection for all
depositors.
Closely related to prudential guidelines is supervision. A strong system of
supervision becomes necessary in order to ensure that the prudential regulations are
followed faithfully by financial institutions. As the financial sector grows, it is quite
possible to have different agencies supervising different segments of the market and
institutions. In this background two issues arise. One relates to the coordination
among supervisory agencies and other regarding consolidated supervision. Financial
institutions no longer operate in one segment of the market. Under the circumstances,
the segmentation of the market for regulatory purposes can run into a number of
difficulties. Apart from multiple authorities exercising control over one institution,
differing prescriptions by different authorities can also lead to inconsistencies and
conflicts. It is in this context that the concept of lead regulator has emerged under
which one authority is recognised as a primary regulator in relation to one type of
institution.

1991 and After: The Reform Years:

 The reform in the financial sector was attuned to the reform of the economy,
which now signified opening up. Greater opening up underscores the importance of
international best practice quickly since investors tend to benchmark against such best
practices and standards. Since 1991, the Indian financial system has undergone radical
transformation. Reforms have altered the organisational structure, ownership pattern
and domain of operation of banks, DFIs and Non-Banking Financial Companies
(NBFCs). The main thrust of reforms in the financial sector was the creation of
efficient and stable financial institutions and markets. Reforms in the banking and
non-banking sectors focused on creating a deregulated environment, strengthening the
prudential norms and the supervisory system, changing the ownership pattern, and
increasing competition.